Trading Fundamentals: How To Use Oscillators Correctly!

Technician Updated   
FX:EURUSD   Euro / U.S. Dollar
Note: A prerequisite tutorial about trends is posted in the related links below.

Oscillators can be a very useful indicators in trading if used correctly. However misusing them will only return disappointing results.
Some of the most popular examples of oscillators are the stochastics, and relative strength index . I will use stochastic in this tutorial, but the same logic applies to most other oscillators.

What are oscillators:
Oscillators are indicators that derive their value from the price . The price is an input for the oscillator formula. The formula is usually a simple calculation that compares the latest close value for the price to a the range of price over a specific period of time( u can change this period in the oscillators settings). Then give the result in a percentage format(0 to 100). The main purpose of this calculation is to show whether the price is overbought or oversold compared to that period range. For example: if stochastic reading is at 80% or above, its said to be overbought. And if at 20% below it is oversold.

When the price is making new highs and the oscillator fails to make a new high, this is called a bearish divergence. The opposite is true, when the price is making new lows and the oscillator fails to make new lows this is called a bullish divergence. Bullish divergence is a buy signal and bearish divergence is sell signal.

If you follow the overbought and oversold signals and divergences as a sell and buy signals without taking in consideration the price trend, the results will be catastrophic. ill explain why shortly

How to use oscillators to maximize your chances:


Rule #1: Oversold signals in uptrending market is a reliable buy signal.
Overbought signals in downtrending market is reliable sell signal.

Look at the chart, start from the left, you can see that the price broke above the latest swing high for the prior down trend, And that signalled a potential reversal. Accordingly, a trader should had looked to buy new oversold signals on stochastic. Afterwards, every time the stoch. was oversold in this uptrending market, we witnessed a rebound and resumption of the uptrend.
Same logic should be applied to downtrending market.

Rule #2: Overbought doesn't mean sell if occurs in an uptrend, and oversold doesn't mean buy if in downtrend.
Rule #3 : Bearish divergence doesn't mean sell if occurs in an uptrend, and bullish divergence doesn't mean buy if occurs in a downtrend.

This might be counter intuitive, but the chart above gives a clear example:

As you can see on the chart, when the market is up-trending, overbought, and bearish divergences signals are very common due to the fact that there is a strong demand. Therefore these signals are NOT RELIABLE and should be ignored. UNLESSthere are other major multiple technical indications of reversal such as a major resistance level, and a bearish candlestick formation, or trend structure break. Same logic goes for down-trending market, where you should ignore oversold signals and bullish divergences.

At the end of the chart, another example of a bearish breakout below the uptrend structure. That was an early signal of a new downtrend. After that breakout, traders should look to sell new OB signals on stochastic.

Overbought and oversold are reliable on a sideways market. Have a look at the image below

If you spot a side-ways market, look to buy oversold signals and sell overbought signals. As the price tends to reverse direction near the top and bottom of the range. If the range is broken, you should exit your trade and stop applying the the logic of sideways market. instead look to apply the logic of the trending market explained above.

Hope this will help you trade better
Here is another example. You can clearly see how the price continued to trend higher while stochastic in overbought. Also multiple bearish divergences weremclear yet the price continued higher.

There is an example of a bullish divergence in an uptrend in the chart above(Jan 25). I outlined it on chart. A bullish divergence in an uptrend is another reliable buy signal.
Here is an example of how unreliable oversold signals and bullish divergence in downtrending market. This time with RSI.


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