By Taro Hideyoshi
What is the oscillator?
An oscillator is a technical indicator that tells at a glance whether a security currently trades in an “overbought” or “oversold” condition.
What are the meaning of “overbought” and “oversold”?
Overbought means the security is trading at the upper extreme of its current price range and may be vulnerable to a correction.
Oversold means the security that scraps the bottom of its current price range and is due for a bounce up.
Relative Strength Index (RSI)
A load of oscillators is available for study and use in trading, each has its pros and cons. However, the one we will discuss in this article is a basic and most popular one. It is available in every charting software, the Relative Strength Index (RSI).
The RSI was introduced by Welles Wilder in his book “New Concepts in Technical Trading Systems“. It measures a particular security’s current relative strength by comparing to its own price history.
The features of the RSI are as follows.
– The RSI also forms the same chart patterns as price, e.g. head & shoulder, double top, double bottom.
– The RSI can be use to indicate support and resistance to confirm price pattern.
– Like many indicators, the RSI supports buy/sell decision when divergence occurs.
General rules of RSI that trigger entering trade:
– Buy a stock while its RSI is in oversold zone and hooking up from 30
– Buy a stock when RSI is hooking up from below 50 with an uptrend (you can draw a trend line for RSI just like draw it for price)
– Buy a stock when it’s forming a bullish divergence.
– Just reverse the rules if you want to sell instead of buy
Typically, the default time period of RSI in most charting software is 14-day. As you gain more experience, you can tweak the time period to a faster or slower that suit your trading style. The shorter time period, the more volatile the RSI become.
An important drawback of oscillators, including RSI, is when the security traded in a strong trend for an extended period of time. The oscillator will rise/fall and stay glued in the overbought/oversold zone while the trend continues.
As I have mentioned, they are many oscillators. They have their own advantages and disadvantages. Novice traders limit their oscillator to only one. While Professional traders keep learning to get sense of alternative benefits each one offers. They do not afraid of replacing one with the better.
About the Author
Taro is an experience trader who trades in stocks, futures, forex. He strongly focuses on technical analysis, trading systems and money management.
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