What is an Oscillator?

Welcome to the Investors Trading Academy talking glossary of financial terms and events.
Our word of the day is “Oscillator”.
An oscillator is a technical analysis indicator that varies over time within a band above and below a center line, or between set levels. Oscillators are used to discover short-term overbought or oversold conditions. Oscillators are most advantageous when a clear trend cannot be easily seen in a company's stock such as when it trades horizontally or sideways. Oscillators represent another widely used group of technical analysis indicators. They are popular mostly because of their ability to draw attention to a possible change in the trend even before this change starts to manifests itself in price and volume. They should work best in periods of sideways markets.
Oscillators are together with moving averages the most commonly used indicators in technical analysis. They take the form of lines that are drawn under the price chart for the particular stock. Oscillators got their name according to the fact that their values tend to oscillate in a certain range. We can analyze current market situation according to the indicator's position within this range. A typical oscillator moves in a manner similar to a sine curve between its two extreme values. There is a vast array of oscillators, many of which are very similar. Here we will present the most commonly used types.
Oscillators are primarily used as leading indicators - so their purpose is to inform us about a possible start of a new trend or its reversal. Two things are important to watch for here - the current reading of the oscillator as well as the trend the oscillator's values follow. The current value of the oscillator usually describes current strength of the trend. If the values are rising, trend is gaining momentum and prices are changing faster. Conversely, if an oscillator's values are decreasing, prices are changing at a slower pace and trend is losing strength, which can imply its reversal in the near future.
Besides, oscillators are also used to detect imbalances in the market. For example, if the price is rising too quickly, the oscillator reaches a level at which the market is considered overbought. At this level the price is rising too quickly compared to the previous periods. It is highly probable that such a steep rise will be followed by a short-term price correction or at least by a loss of momentum in the trend that will restrict the price rise for some time. Similarly, if the oscillator reaches an oversold level, it implies that price is falling too quickly. It is probable that the decline will ease or stop completely for some time. In some cases it can be followed by a trend reversal.
The third way how to use oscillators is trying to find divergences between the indicator and market price or volume. For example, if the market price reaches next high that is higher than the previous high, while the oscillator MACD stops its rise at a level that is lower than the previous high, there is a bearish divergence in the market. This implies that prices are rising slower than in earlier periods and the trend is "running out of steam". Such divergence usually precedes the start of a downward trend.

By Barry Norman, Investors Trading Academy