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Building Blocks of Technical Analysis - Oscillators Part I

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In construction, all oscillators are identical. They fluctuate with peaks and troughs in a flat horizontal range. The peaks and troughs in the price chart correspond with these peaks and troughs.

During sideways market conditions, trend analysis loses effectiveness. Fluctuating and varying situations are where oscillators become more and more helpful. However, the importance of oscillators is not limited to non-trending markets and can be of great help in illustrating extended market conditions in the sense of the prevalent trend. Also, the oscillator may provide early warning that either maturing or losing momentum is the overall trend.

Momentum

As compared to the real price levels themselves, Momentum tests the pace of price shifts. Market momentum is calculated by taking price differences over a fixed time interval continuously. In understanding the principle of oscillator construction and implementation, this simple approach makes it very useful.

Construction

Deduct the closing price of ten days ago from the last closing price to measure a 10-day momentum oscillator. It then plots this positive or negative value around a zero axis.

Formula: M= V –Vz or M= (V-Vz) + 100 (to oscillate around 100)

V is the closing price and Vz is z days ago's closing price. If the current closing price is higher than 10 days ago (prices have risen higher), then above the zero line and vice versa, a positive value will be plotted.

How to interpret Momentum

Oscillators share common characteristics and, thus, similar methods of interpretation. A certain degree of focus is placed on particular signals by the various complexities and strengths of the different oscillators. A significant trading signal is the crossing of the zero/100 line, but trend confirmation, extended market conditions and divergence are general oscillator signals that are used when momentum is used.

Benefits and disadvantages of Momentum

  • The method of calculation means that the momentum line will lead the underlying price action. It is, therefore, an early warning device of future reversals of patterns.
  • There is no fixed upper or lower boundary on this oscillator which can measure extended market conditions. There is something of a flaw in historical assessments of overbought or oversold circumstances.
  • A propensity for false signals and whiplashing across the middle line is also present.

MACD

A MACD is a 'Moving Average Convergence / Divergence' indicator developed by Gerald Appel. MACD serves as a warning signal that there may be imminent new developments, whether bullish or bearish. It is the difference (traditionally, a 26-day average and a 12-day average) between a longer-term exponential moving average and a shorter-term exponential moving average. A 'trigger line' (or 'signal line'), which is an exponential moving average of the MACD itself, is then created. It can be used in a way similar to that of moving averages. This is a buying signal as the MACD rises above the trigger line. This is a sale signal when the MACD falls below the trigger line.

MACD Formula

The difference between the 26-day and 12-day Exponential Moving Averages (EMAs) of a security is the most common formula for the "ordinary" MACD. Since then, Appel and others have tinkered with these original settings to come up with a MACD that is ideally suited for shares that are faster or slower. A faster, more sensitive indicator will be created by using shorter moving averages, while a slower indicator, less prone to whipsaws, will be produced by using longer moving averages. The traditional 12/26 MACD for our purposes will be used for explanations.

The 12-day EMA is the quicker of the two moving averages that make up MACD, and the 26-day EMA is the slower. To form the moving averages, closing prices are used. Typically, MACD's 9-day EMA is plotted next to it to serve as a trigger line. When MACD moves above its 9-day EMA, a bullish crossover occurs, and a bearish crossover occurs when MACD moves below its 9-day EMA.

MACD Interpretation

The MACD oscillator shares similar evaluation methods to most other oscillator experiments. Such technological signals are rarely viewed in isolation but the combination with other indicators of MACD and evaluations of market behavior. The principle of confirmation and divergence for technical research remains true.

  • Overbought and oversold situations constitute historical lows and highs. Such levels are used as an early warning sign by seasoned practitioners that a top/bottom could be forming.
  • Via its moving average, a break of the MACD line is called a "trigger" and usually confirms the reversal of trend potential from prolonged market conditions. This is the key signal of this oscillator for purchasing and sale.
  • Another early indicator that the market is losing directional momentum and a turning point may be approaching is the divergence of the MACD oscillator to underlying market movements. New highs or lows can still be generated by the underlying market, whereas the oscillator struggles to hit new highs/lows at the same time. Divergence is only valid and effective at extended market levels when it happens.
  • Further proof of an already proven directional pattern is the break of the zero axis. This signal is somewhat delayed and not always conducive to an investment or positioning being initiated. It is usually used to describe the market as being bullish or bearish in general.
  • An early warning via trend lines and formations about market breaks. "Trigger" events on the MACD oscillator and trend line breaks could occur as an early signal before a subsequent step on the underlying market. This implies that oscillator trend lines and formations are as real as on the underlying price map.

Summary

The MACD is a multifaceted oscillator that is commonly used to support most other related studies. The general oscillator weakness of limited applicability should be noted in a highly trendy market, particularly during the initial stages of a trend. The method of calculation also does not allow for a quantifiable estimation of extended market conditions, and it is essential to take historical levels into account in this regard.

Thank you for reading and hope you have a good rest of the day!

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