From the desk of Nikolas Xenofontos, Director of Risk at easyMarkets.
The study of technical analysis, which analyzes past price action to predict future price movements, incorporates a number of methodologies used to evaluate price movements. One of the most useful is the ability to define momentum, and the rate of change a security is experiencing. An oscillator is a calculation of past prices changing to reflect the rate of change and whether prices have reached extreme levels. The most commonly use oscillators studied to analyze the Forex market are the stochastic oscillator, and the relative strength index (RSI)
The stochastic oscillator is a momentum technical indicator that measures extremes and momentum by creating an index based on the high/low range of prices over a specific period. The goal of the oscillator is to follow the acceleration in prices. The theory is predicated on the idea that prices follow momentum. An example would be to think of the momentum you have when you are driving a car, as momentum accelerates the likelihood of continued follow-through in your direction increases. Stochastics can also represent pivot points that reflect extreme values where prices are likely to revert.
The most common setting for the Stochastic Oscillator is 14 periods, which can be any time frame from months to intra-day. The highest high over the last 14 periods and the lowest low over the last 14 periods, are compared to the current period. A 3-day moving average of the relative period is then compared to the current period.
The chart above, of the full stochastic, identifies crossover periods when the fast stochastic crosses above (or below) the slow stochastic, as well as the absolute value of both stochastics. When the fast stochastic crosses above the slow stochastic, it generates a buy signal that identifies increasing positive momentum (the red line crossing above the green line). The reverse is true when the fast stochastic crosses below the slow stochastic reflecting a period of increasing negative momentum.
The absolute value of the stochastic can also be helpful in finding periods when a security is overbought or oversold. A stochastic level above 70 is considered overbought and a stochastic level below 30 is considered oversold.
By combining the extreme readings of the stochastic with the crossover signal, you can find levels where momentum is accelerating when the index was recently oversold, or where negative momentum is increasing when the index was recently overbought (black arrows).
Another oscillator is the relative strength index (RSI). Generally the RSI is used more exclusively in determining overbought and oversold levels rather than depicting periods where there is a change in momentum. The RSI is an index that is derived from subtracting 1/the average gain for a period minus the average loss from 100. RSI readings above 70 are considered overbought and RSI reading below 30 are considered oversold. The RSI helps find price levels where a change in direction is likely, but it may be best used in conjunction with other indicators that will be more specific about an entry level.