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Forex Oscillators – The Predictive Value of Divergence and Convergence

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Oscillators give the trader limit values which he can use to evaluate the price action. The currency price is a number, and its range is limitless (it can move between zero and infinity). It’s impossible to define a high and low on that range, and oscillators are used to overcome this problem.

Divergence and convergence, as they are termed, are held to offer predictive value by the technical analyst, since their occurrence is less common than the usual parallel movements of the trend and the oscillator.

Let us examine them briefly.

Divergences and convergences

A divergence occurs when a new high in a price trend is not confirmed by a corresponding new high on the oscillator, but instead is contradicted as the oscillator registers a new low. Its opposite, the convergence, occurs when consecutive trend lows are contradicted by consecutive highs on the oscillator.

Divergences or convergences can occur on all kinds of oscillators, and they signal that the trend is in peril of losing strength, possibly even reversing. As usual, the signals they emit can easily be contradicted by the eventual price action, and the trader should always be cautious when interpreting them. Nonetheless, such patterns can give an early warning of an eventual trend reversal especially when they’re backed by other kinds of data provided by other methods.

A bullish divergence is thought to signal the reversal or consolidation of an upward trend. As the oscillator fails to confirm the price action, the technical analyst will suggest that the market actors who drive the trend are close to being exhausted, and the trend is unlikely to be sustained in the absence of shocks, so to speak, such as news events, new liquidity, and so on. In general, a divergence is a sign that, while the speed of the trend may still be healthy, the accelerator of the price action is weakening. Divergences and convergences are believed to inform us that the background force creating the momentum is no longer there, and it’s up to the trader to interpret the signals.

Bearish convergence is the opposite of bullish divergence, and the trend on the oscillator and price action converge on each other, signifying a possible reversal of the underlying bearish trend.

Parallel lines

The third scenario with respect to the counterpoint between the oscillator and the price trend is emergence of parallel lines. Since prices most of the time trend, parallel lines are the most common phenomenon in the markets, and consequently their predictive value is even more limited than convergences or divergences. The most they signal is that the price trend is intact, and the oscillator is not giving any appreciable signs as to its eventual direction.

What kind of oscillator is most useful for the trader? Consistently used, any indicator can be helpful in depicting the technical patterns behind the price action. In other words, as long as the trader doesn’t use different types of indicators for analyzing different periods of the trend, the technical picture can be utilized in determining the direction of the price action, and maybe its strength. While it’s of course true that different indicators will be more successful at different time periods, their periods of success are arbitrary, and the trader should not be distracted by seeking the correct indicator for “the moment”. A strategy based on technical analysis is not likely to succeed if it doesn’t make room for the fact that oscillators, and other types of indicators are fallible.

Oscillators have received general acceptance among traders over the years, and we will examine a number of them.

RSI

RSI is a popular indicator widely used by both the professional and amateur analyst because of its clarity and the straightforward signs generated by it. It was created in 1978 by J. Welles Wilder, a mechanical engineer and commodity trader, who is also the inventor of the Average True Range, Directional Movement and the Parabolic Stop and Reverse.

The RSI depends on a simple formula, and there are ample resources on the internet where the curious reader can learn about the mathematics. But such mathematical knowledge is hardly a necessity for the trader, since the indicator is as refined and simple as it can be, and it’s highly unlikely that any change to its internal mechanics will yield any significant changes in profit.

In general, a buy signal is generated when the RSI is above 30 and rising, and a sell signal is generated when the indicator is below 70 and falling. In the example below, the RSI generates a buy signal at 20 because the market which it’s analyzing is supposed to be a bear market; as the market is more likely to have a preponderance of sellers, we want to take only the strongest buy signs, and the RSI at 20 is stronger than the RSI at 30. If the market had been a bull market, we could have held the buy signal at 30, but moved the trigger line for a sell order to 80 in order to give less credence to the countertrend signals generated by this indicator. In the same sense, the standard trigger levels at 70 and 30 are best suited to a ranging market that doesn’t possess the potential to break out, at least according to our analysis.

Get the RSI formula and also see the RSI in a graph here.

Williams % R (percentage range)

The indicator was developed by Larry Williams, who was the first and so far the most successful winner of the World Cup Championship of Futures Trading in 1987. He was able to turn a $10,000 real account to more than one million dollars in the course of a single year. Interestingly enough, his daughter Michelle Williams also won the same contest in 1996 by turning $10,000 into $100,000, which was the second best result in the history of the competition.

The indicator subtracts the high of the previous n-days (the number n determined by the trader) from today’s closing price, and then compares the difference with the high-low range of the n-day period. The result, which is a number between 0 and -100), is then used to reach a conclusion about the direction of the trend. Larry Williams’ favorite period was ten days, and longer periods will give safer (but later) signals, while shorter periods will provide timelier but less reliable results.

As with the RSI, the convention is to regard a level above -20 as a sell signal, while considering indicator levels above -80 as buy signals.

If you’re curious about the difference between using this indicator instead of RSI, we can provide you with a little guidance. The Williams oscillator is essentially a much more sensitive and volatile version of the RSI. While the RSI is based on moving averages (and therefore is far smoother), the Williams oscillator is based directly on the price action, and so it’s more prone to generating many more false and conflicting signals.

Its inventor, Larry Williams, overcame this problem by accepting its signals only at very extreme levels: he would act only if the indicator value reached -100 (instead of the above-mentioned -80), and stayed at around that level for five days, before deciding on a buy order, and doing the reverse for a sell order. He was thus able to capitalize on the price-sensitivity of the indicator, while avoiding (hopefully) false signals and volatility.

Get the Williams Percentage Range formula and see it depicted in a chart here.

Stochastics

The stochastics oscillator was invented by George Lane, an Elliot Wave theorist, in the 1950’s. It’s purpose is to spot the tops and bottoms in a developing trend for profit, but it can also be used, perhaps to better effect, in ranging markets.

The stochastics oscillator has a fast (%K) and a slow (%D) component, and the interactions between the two form the basis of analysis. As usual, there’s no need to go into the details of the formulas, because the underlying principle is easily understood even without the usage of any mathematics.

The fast (%K) component of the indicator is just the Williams %R oscillator, although the scale is reversed to 0-100, instead of the unusual -100 to 0 of the original indicator. The slow component (%D) is the SMA (simple moving average) of the %K component. Since with simple moving averages a buy or sell signal is generated when the faster moving price action crosses above or below the slower SMA, it should be easy to understand why the same signals are generated when the fast component (%K) similarly crosses above or below the slow component (%D), which is the SMA of %K.

So what does the stochastics indicator do? It takes the price action, generates a Williams oscillator, generates the SMA on the Williams oscillator, and then creates signals based on the crossovers. As usual with technical analysis, there are other methods for using the stochastics indicator, and we’ll here add two more ways.

Many traders use the stochastics indicator to generate buy and sell signals in a way similar to the RSI, and the oversold and overbought levels are thought to be 20 and 80, respectively. In short, the trader will wait until either the fast or the slow component of the oscillator reaches these levels, and once the indicator changes direction, he’ll enter a new trade corresponding to the signals that the indictor emits.

Another way of using the stochastics indicator (as with all the other oscillators) is through utilization of the divergence method. The trader will buy when the stochastics oscillator registers a bullish divergence with the price, and will sell, similarly, once a bearish convergence emerges.

Of course, the trader doesn’t need to follow any of these concepts blindly. He can use one of them, or any combination of them, in any way that he sees suitable.

Learn more about the stochastics indicator here.

MACD

The MACD, or the moving average convergence divergence indicator was developed by Gerald Appel in the 1960’s. It is one of the favorite tools of technical analysis, and, it is used best in trending markets, with unsatisfactory results when it’s used in ranging conditions.

MACD consists of three separate indicators, and its signals are generated through the interaction of these components. The indicators are all exponential moving averages (EMAS), and they differ only in their periods. By using three price sensitive EMA’s the indicator aims to gauge the trend’s strength.

The value of MACD is determined by the difference between the 12-period exponential moving average and the slow 26-period exponential moving average which then is depicted in the shape of an histogram. The difference is then plotted on the 9-period EMA (the signal line).

The signal generated by MACD is bullish if the indicator’s value is positive, and bearish if it is negative. The existence of a divergence or convergence between the signal line and the price action is thought to show that the price is weak. With respect to the signal line, there are two additional scenarios: if MACD (the histogram) is below zero, and there’s no bearish convergence, a bullish signal is thought to be generated when the histogram crosses the signal line. Conversely, if the MACD is above zero, and there’s no bullish divergence, a bearish signal is generated when the histogram crosses the signal line and continues to trend upwards.

The most important point to be remembered when using MACD is that it’s a lagging indicator, in other words, it will report on a trend change only after the moving averages, themselves lagging indicators, have registered it. Since trends change rapidly in the forex market, and also because price movements, at least in the short term, are chaotic, and highly volatile, the lagging nature of MACD makes it perhaps even more likely to generate false signals. The trader is advised to carefully monitor other developments in the market before acting on the signs emitted by the indicator.

Learn more about the MACD here.

Average True Range

Another indicator developed by J.W. Wilder, the average true range (ATR) aims to capture the strength of a trend by comparing the high and low of today with yesterday’s close. To decide the value of the indicator, the charting software will pick today’s range (high-low), or one of the two so-called true ranges (today’s close-yesterday’s high/today’s close-yesterday’s low), whichever has the greatest absolute value. These values are then compounded into a price sensitive EMA (exponential moving average), and conclusions regarding trend strength are drawn based on its value.

ATR behaves on the principle that the higher the ranges (and perhaps volatility, as a result), the higher the interest of traders and their excitement, and the closer the reversal of the trend. In other words, it’s a contrarian indicator, which gets more skeptical of the trend as the traders get more enthusiastic and excited. The potential for a trend change is as high as the value of the ATR indicator, while weaker values are thought to signify a developing, or stagnating trend.

See the ATR indicator depicted in a chart here.

Momentum indicator

The momentum indicator measures the strength of a trend based on price differences on a specified (n) time period. There are two ways of calculating it, and one simply subtracts the price of (last-n) bar before from the price of the last bar, while the other divides the latter by the former, then multiples it by a hundred to get a percentile value. The formula are

M1 = Price of the last bar – price of the (last-n) bar

Or

M2= (M1/price of the (last-n))*100

In example, if the price of EUR/USD is now at 1.2322, and four minutes ago it was at 1.23 on a one-minute chart, when we set the period at 4 for the M indicator, the results we get for the value of the M indicator are

M= 1.2322-1.23 = 0.22 or (0.22/1.23)*100= 17

The interpretation of the second version of this indicator is made on the following principles

1. If M is less than 100, the momentum indicator suggests a sell order

2.When it is more than 100, the momentum indicator suggests a buy order.

3. when the indicator is 100, there’s no signal.

4. When the indicator moves from 100 to above or below 100, the signal is to buy or sell, respectively.

The momentum indicator captures the direction of the trend and its value increases as the trend turns bullish, or less bearish. It is a simple and uncomplicated method of gauging trend strength, quite similar to a cursory visual evaluation, and this is also where it’s strength lies, because it can be quite effective at describing the trend when combined with other types of indicators.

More about the momentum indicator including a chart here.

Commodity Channel Index

Originally published by Donald Lambert in 1980, the commodity channel index (CCI) is another oscillator that has grown to be very popular among traders of not only commodities, but also currencies and stocks since its creation thirty years ago.

In a ranging market, Traders regard values of the CCI above +100 as overbought territory, while values below -100 are considered oversold. But for safer signals in trending markets, the indicator will be combined with other types of data, and divergences or convergences between the price and the oscillator will be sought to provide clues on the direction of the trend. A bullish divergence implies that a downtrend is in danger of reversal, while a bearish convergence suggests that a bullish trend is likely to run out of energy soon. Also, as with other oscillators, when the price breaks the flat line (indicator value is zero) the direction of the breakout is also thought to signal a buy or sell order.

The CCI was originally used in the commodities market for identifying extreme conditions that would create trading opportunities. Because of the highly cyclical nature of commodity markets, and the resulting oscillating pattern created by prices, the CCI was very successful in clarifying market direction. As currencies often demonstrate similar behavior in response to interest rate cycles of the central banks, this indicator can be very useful in trading the long term movements of the forex market.

Learn more about the commodity channel index indicator here.

Force Index

The force index is another oscillator and it is used to measure the force of the trend during upward or downward movements.

The index is calculated by multiplying the difference between the last and previous closing prices with the volume of the trend. As with all oscillators the force index can be used to calculate divergences and generate signals based on them. It is also possible to smooth out the fluctuations in the index value by taking a simple or exponential moving average of it. This reduces the amount of noise generated by the indicator, and is useful for analyzing strong and long-lasting trends. Most software and trading platforms today use not the raw index, but the smoothed version of it.

Alexander Elder, who created the index, suggests that traders buy the trend when the index value is below zero and there’s a bullish divergence, and conversely, to sell it when the when the index value is above zero and there’s a bearish convergence.

Final Word

With a good knowledge of these indicators, or at least of their components, the novice trader can avoid cluttering his screen with lots of indicators and trend lines which all depict the same thing. There is, for instance, little point in drawing lots of EMA’s on the screen if the MACD is already in the background. Likewise, drawing the Williams oscillator and Stochastics is just a waste of energy, since Stochastics is already providing the trader with all the information that that indicator can give. Nor is there much benefit in using trend lines if an automatically drawn simple moving average is already doing all that trend lines can do.

Read a great article and learn many of the most common price patterns.


Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.


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