Stocks & Commodities V. 11:4 (174-177): Oscillator Variations by Barbara Star Oscillator Variations by Barbara Star Here, Barbara Star takes a 1985 STOCKS & COMMODITIES article by John Navarte called "Reading between the lines" and uses it as the basis for a tutorial on oscillators for trading. Oscillators are handy tools for traders. An oscillator plots the difference between two sets of data. Popular methods include the difference between the current closing price and a moving average, the current closing price and a closing price n periods ago or the difference between two moving averages. Traders use oscillators to identify changes in market momentum, temporary price extremes within trends and changes in market trends. Some traders smooth the oscillators with a moving average to identify changes in the direction of the oscillator. In "Reading between the lines," John Navarte examined methods for calculating and interpreting oscillators. His first concept was price excess. PRICE EXCESS The price excess indicator shows when a tradable (that is, stocks, commodities and so forth) is too high (overbought) or too low (oversold) relative to historical extremes by comparing the price fluctuation to the fluctuation of its moving average. The price excess oscillator compares the difference between today's close and the security's 24-day moving average. This indicator can be closely approximated without a custom formula (see sidebar, "MetaStock custom formula") by selecting the price oscillator indicator offered on many charting packages and choosing the value "1" as the shorter-term moving average and "24" as the longer-term moving average, both as simple moving averages. Navarte suggested plotting a 12-unit simple moving average on the indicator to better see when the oscillator would turn. Buy and sell signals would be generated when the oscillator crossed the moving average. Figure 1 illustrates the price excess oscillator with a daily chart of the New York Stock Exchange (NYSE) Composite. In addition, the oscillator works well with weekly data. Smoothed price excess: In "Reading between the lines," Navarte provided a smoothed version of the Article Text 1
FIGURE 1: PRICE EXCESS OSCILLATOR AND THE NYSE. The price excess oscillator with its (dotted) 12-day simple moving average helps determine when a market is overbought or oversold. Buy or sell signals would occur when the indicator crosses the moving average. FIGURE 2: THE SMOOTHED PRICE EXCESS OSCILLATOR WITH THE NYSE COMPOSITE. Smoothing the price excess oscillator produces a less jagged line and reduces the number of false buy or sell signals.
Stocks & Commodities V. 11:4 (174-177): Oscillator Variations by Barbara Star oscillator that removes the shorter-term price swings and reduces the number of false signals to smooth the jagged appearance of the price excess indicator and to prevent whipsaw behavior. Navarte smoothed the oscillator by subtracting the 24-unit simple moving average from a six-unit exponential average of the close. Once again, a 12-unit simple moving average was applied to the oscillator to help confirm the changes in direction. Now compare the results of the smoothed version in Figure 2 with the original formula shown in Figure 1. Note the jagged appearance of the price excess oscillator in Figure 1 compared with the oscillator in Figure 2. The smoothed version in Figure 2 reduces the day-to-day volatility of the price excess oscillator while still highlighting the changes in trend direction. Oscillators are best used in trading range markets rather than trending markets. OFFSET MOMENTUM The offset momentum oscillator is another useful oscillator, one that indicates when a price move is gaining power or losing steam. According to John Navarte, momentum oscillators are useful for studying the rate at which price changes from day to day. Momentum oscillators often give advance warning of price reversals when the rate of price change slows down during a price move. Navarte suggested constructing a 12-unit simple moving average with a four-day offset that is, subtract from today's 12-unit simple moving average the value of the 12-unit moving average as of four days ago. Navarte plotted a six-unit simple moving average on this indicator to help spot changes in trend. Figure 3 shows the offset momentum oscillator using Eastman-Kodak (EK) stock. Navarte warned those who wish to experiment with the length of the moving average and/or the number of days in the offset that the offset chosen should be as small as possible to provide a reasonable fit with the price chart and individual trading style. One example might be a 12-unit moving average with a one-day offset. Smoothed offset momentum: Longer-term traders might prefer a smoothed version of momentum to catch the intermediate-term swings. Navarte suggested a 30-day average with a 10-day offset. Apply a six-day simple moving average to the indicator. See how this indicator (Figure 4) eliminates the shorter-term price movements of Figure 3. ADDITIONAL IDEAS Here are a few ideas not mentioned in the original article by John Navarte: 1 Offset momentum crossover. Plot the regular offset momentum oscillator. Then overlay the smoothed offset momentum oscillator as shown in Figure 5. When offset momentum crosses smoothed offset momentum, it warns the trader to start looking for topping or bottoming price action. The buy or sell signal occurs when smoothed offset momentum either shows a divergence, as it did in the August-September period, or crosses its zero line, which happened near the beginning of October. Another pattern I noticed was the tendency for the smoothed offset momentum indicator to flatten out (that is, move sideways) during minor countertrend price corrections. (Note the price decline in July and price rallies in mid-september and in late October.) These plateaus indicate that the major trend has not yet changed. Article Text 2
FIGURE 3: THE OFFSET MOMENTUM OSCILLATOR WITH EASTMAN-KODAK. Despite the rising prices from June to the beginning of September 1992, the offset momentum indicator shows that Eastman-Kodak (EK) made its momentum high in July and had been losing steam since. To prevent an early exit that would have resulted because of the divergence between the indicator and the price, it is often wise to confirm a buy or sell signal by waiting until the indicator crosses the zero line. FIGURE 4: THE SMOOTHED OFFSET MOMENTUM OSCILLATOR WITH EASTMAN-KODAK. The smoothed offset momentum indicator looks like a better trading tool for the person who prefers a more intermediate-term trading approach.
FIGURE 5: OFFSET MOMENTUM CROSSOVER WITH EASTMAN-KODAK. The shorter-term offset momentum indicator (dashed line) is overlaid on the longer-term smoothed offset momentum indicator (solid line). The value of the shorter-term indicator is shown on the left side of the scale and the value of the smoothed indicator is displayed on the right side of the scale. The crossover points of the two indicators forewarn an impending top or bottom. Confirmation of a trend change occurs when the smoothed indicator shows a divergence with price (August- September timeframe) or crosses its zero line (early October). FIGURE 6: DUAL HISTOGRAMS WITH DECEMBER 92 SWISS FRANC. Viewing the smoothed price excess indicator and the smoothed offset momentum indicator using a histogram, rather than a solid, line style seems to work well in trending markets. Price excess shows the fluctuations in price during countertrend corrections as in August and in September, while the smoothed offset momentum clearly shows the divergences in the September-October timeframe as price continued to rise. Drawing a trendline on the price chart confirmed the October change in trend when smoothed offset momentum dropped below its zero line.
Stocks & Commodities V. 11:4 (174-177): Oscillator Variations by Barbara Star 2 Dual histograms: Change the line style from a solid line to a histogram line on both the smoothed price excess and the smoothed offset momentum as in Figure 6. This presents the same information as the solid lines but accentuates oscillator movements above and below the zero line. It also identifies divergences very clearly. Shorter-term traders may want to try this with the regular price excess and the offset momentum oscillators. TRADING TIPS Oscillators are best used in trading range markets rather than trending markets. In trending markets they often show divergences with price action that produce false signals, which lead to early exits and/or premature entries, especially for intermediate- to longer-term traders. This pitfall can be reduced by plotting a trendline on the price chart to serve as a confirming indicator of price change, as with the Swiss franc (Figure 6). Barbara Star, Ph.D. is a university professor. She leads a MetaStock support group and is a board member of the Market Analysts of Southern California. Technical support was provided by Allan McNichol of Equis International, Inc. ADDITIONAL READING Navarte, John [1985]. "Reading between the lines," Technical Analysis of STOCKS & COMMODITIES, Volume 3: Chapter 6. 3