Oscillators are used to:
To define if the trend is weak, use bullish divergence / bearish convergence.
Bullish divergence occurs when a new price high is not confirmed by a new oscillator high, i.e the next high is above the preceding one and the next oscillator high is lower than the preceding one. This implies that the uptrend is weak:
Bearish convergence occurs when a new bottom is not confirmed by a new oscillator bottom, i.e. every next bottom is lower than the preceding one and every next oscillator bottom is higher than the preceding one. This signals that the downtrend is weak:
Both bullish divergence and bearish convergence, however, show that it is better to refrain from opening a position against the weakening trend. Trend is valid until reversal signals appear.
It is important to be more careful with oscillators when the trend is strong; often false oscillator signals indicate the strength of the trend. If it is an uptrend then most of the time oscillators are in the overbought area, if it is a downtrend, they are in the oversold area. Overbought and oversold levels have to be defined for each indicator individually.
In the figures above Relative Strength Index (RSI) is used as an oscillator. If the indicator is above 70 then it is in the overbought area, if it is below 30 then it is in the oversold area.
When the trend is strong, the oscillator can be in the overbought (oversold) area for a long time and then it can exit the area but the trend will still be valid.
When the oscillator penetrates the overbought (oversold) area for the second time and then quickly goes back forming a bullish divergence/bearish convergence, there is a high chance that the trend will weaken.
Where the market is flat, it may be time to open a position once the oscillator leaves the overbought (oversold) area. Confirmation of the signal appears when the price is close to the upper (lower) border of the trading range.
Here the price is above and oscillator is below:
Medium signal
The price may rise if the oscillator is within the lower range.
The price may fall if the oscillator is in the middle.
Strong signal
Trend reversal or price consolidation followed by a trend reversal.
Medium signal
Trend may strengthen if the oscillator is close to the lower border.
Price consolidation is possible if the oscillator is close to the upper border.
Both a price increase and price consolidation are possible if the oscillator is in the middle.
Here the price is above and oscillator is below:
Medium signal
The price may fall if the oscillator is within the upper range.
The price may stabilize if the oscillator is in the middle.
Strong signal
Trend reversal or price consolidation followed by trend reversal.
Medium signal
The trend may strengthen if the oscillator is within the upper range.
The price may rise if the oscillator is within the lower range.
Both a price decrease and consolidation is possible if the oscillator is in the middle.
Here the price is above and oscillator is below:
Medium signal
Strong uptrend
Strong signal
Trend may reverse soon.
Medium signal
Strong downtrend.
Trading contest live at the London Investor Show FOREX 24 February 2012
More details
