DIVERGENCE – FORMULA
The Oscillator study plots the difference between two moving averages of different lengths or types. The difference of two moving averages with different sensitivities to market action provides an indication of the development of a change in the market environment, such as the emergence of a new trend or a trend reversal.
To calculate an oscillator value:
- Calculate the moving averages;
- Calculate the difference between them, either arithmetically or as a percentage.
Some of the ways in which Oscillators are used by trading professionals are illustrated in the following chart:
In most cases, oscillators will fluctuate within a relative range around a certain midpoint which is usually zero, which provide an indication as to whether momentum is to the upside or the downside. Therefore, a trading professional may take a long position once an oscillator crosses above the midpoint, or take a short position if the oscillator crosses below it. He or she may then hold the trade until the oscillator crossed back through the midpoint in the opposite direction.
Additionally, the extent to which oscillators are above or below the midpoint also provides information about whether the market has overextended itself in a particular direction, and therefore become Overbought (if too far above the midpoint) or Oversold (if too far below the midpoint). Obviously, this would indicate to traders whether the market was on the verge of a pullback or retracement – which may prompt a trader to initiate a counter-trend trade in the opposite direction of the prevailing market.