Which Way Will The Market Go?

Looking at an oscillator to interpret what a stock or market will do next is sometimes like looking at a mood ring whose color is supposed to tell you the mood of the wearer. Your prediction of what the stock or market will do next will be more accurate if you understand the mood or the momentum of what an oscillator is measuring. Given the right circumstances, an oscillator can be powerful predictors of events.

THE BASIS FOR MOMENTUM

Oscillators are built around the notion of comparing past values to present ones for a given period. They can be as simple as comparing yesterday's price to today's and noting the change between them. Over time, this change forms the basis for momentum.

Oscillators typically have upper and lower limits. You can use those limits as overbought (too expensive) or oversold (too cheap) thresholds. They are applicable to stocks, sectors, or market indexes. Figure 1 shows the general movement and idealized behavior of an oscillator.

FIGURE 1: IDEAL OSCIALLTOR MOVEMENT. Oscillators move up and down between extremes. Crossing thresholds is an indication that momentum may lessen. Lessening momentum at the upper extreme indicates buying momentum is at a peak, while lessening momentum at the lower extreme indicates selling momentum is at a peak.

What causes a stock to oscillate? Think about it: a market is a place that consists of buyers and sellers. When stock prices are expected to go up, you will see a lot of buying. If the buyers sense that prices will no longer move up, they begin to sell. During the initial stages of a movement up the momentum is strong, but as buyers sense that prices are becoming too high they back off and momentum slows.

The same is true when it comes to selling. At the highest price, sellers sense an urgency to absorb all the profit they can. As the price gets lower, the urgency to sell lessens. The rate of change is strong in the beginning and then peaks. This buying/selling mood is what gives an oscillator its characteristic shape.

Do all stocks oscillate? At some point, they usually do. Some may seem to be going up or down all the time. The ideal oscillator candidate is a stock or sector moving between two extremes; the stock moves sideways, moving up and down in a price channel. This gives you an opportunity to buy a stock or invest in a sector when it is oversold, or sell when it is overbought.

As an example, let's use the stochastic oscillator (upper chart, Figure 2). This oscillator is available at most Internet sites that provide charting. You can see from Figure 2 that the stochastic does go up and down; the threshold values of 80 and 20 are the accepted standard. How can an oscillator move between the same extremes when the General Electric price (bottom chart) is so different at times?

FIGURE 2: GENERAL ELECTRIC (LOWER CHART) AND STOCHASTIC OSCILLATOR (TOP CHART). General Electric went through two uptrends and then a downtrend before oscillating in a price channel from mid-March 2000 through mid-August 2000. The optimal time to use an oscillator is when the stock (or sector or market) is in a price channel.

But Figure 3 doesn't show the stochastic as crossing the oversold threshold! Where are the buy signals? Shown is GE's performance on a weekly basis, whereas Figure 2 displayed a daily chart. At times, there will be enough up-and-down movement to show effective signals, but Figure 3 shows that in a trend you may find that an oscillator will not cross a threshold and therefore oscillation is not effective.

FIGURE 3: GENERAL ELECTRIC (WEEKLY) AND STOCHASTIC OSCILLATOR. Oscillators work best when there is no trend. No oversold condition using stochastic was reached until 2000. Buying and holding from 1996 on is the best strategy when an uptrend is underway.

DIVEGENCE

Besides indicating when an oversold or overbought condition exists, oscillators also provide insight into a divergence. As you can infer from the name, a divergence occurs when two conditions move in opposite directions. In this case, the opposite actions are the directions of the oscillator and price trends. Figure 4 depicts this scenario.

FIGURE 4: DIVERGENCE. Price can continue up while momentum has turned and is headed down. When the price trend continues moving up and the oscillator trend moves down, a divergence has taken place.

A divergence occurs when price keeps going in one direction, but momentum goes in the opposite direction. When a stock (or sector or market) reaches a top, most of the buyers are getting out, but overexuberant buyers persist on buying and the price continues up. Identifying divergences is in fact the most powerful way to use an oscillator.

The key to using an oscillator is using the right one(s) at the right time, since each provides a slightly different type of analysis. The stochastic measures strength relative to the price range of several days ago. If a stock or sector continues to go up above the top of its price range, it tends to "bump its head" on the upper limit. When a stock or market is in a strong uptrend, you need an oscillator that measures its current strength relative to the past. Another popular oscillator, the relative strength index (RSI), on the other hand, uses the average price at the market close and divides average price closes that are up by those that are down. This ratio will help determine if price on average is moving up faster than it is moving down.

The chart of Yahoo! (YHOO) in Figure 5 shows prices going up in December and RSI momentum going down. In this situation, divergence has occurred because price and momentum are moving in opposite directions. Remember that oscillators reflect behavior, so what happened here is that RSI hit a peak earlier than prices did and started to decline before prices did. As a consequence, each attempt to move up has less oomph -- less momentum -- hence creating the downtrend.

FIGURE 5: RELATIVE STRENGTH INDEX (TOP CHART) AND YAHOO (BOTTOM CHART). Yahoo reaches a peak in its momentum as measured by RSI. After reaching a peak, the momentum has less strength each time RSI tries to go back up and forms a downtrend. Price continues up, creating a divergence in price and momentum trends. A few investors drive up the price, while the majority are poised to sell. When selling does come, it comes fast.

SUMMARY

Oscillators are independent of the stock or sector; the exceptions are oscillators specifically designed to look at an entire market. Because oscillators measure momentum, they can tell us if something is overbought or oversold; they can tell us if there is a divergence between price and momentum trends; they can even tell us the mood of buyers and sellers. Finally, using the correct oscillator at the right time can increase the accuracy of your analysis, and choosing the right oscillator at the right time can be accomplished if you understand what an oscillator is measuring.

Dennis Peterson can be reached at DPeterson@Traders.com.