A currency pair can become too cheap (oversold) or too expensive (overbought). When this happens, it signals a market reversal.
Why? Simple: Traders buy the low and sell the high.
When the bullish market becomes too expensive, the buyers will lock in their profits, and the sellers will intervene.
When a bearish market becomes too cheap, the sellers will exit their position to lock in profits – giving buyers an entry opportunity.
When the bulls and bears respectively intervene in a bearish and bullish market – the trend will reverse.
Read on this lesson to learn how to use oscillators to spot the end of a trend.
Technical traders use oscillators to gauge the strength and momentum of a trend.
Briefly, it suggests that a change in momentum entails a weakening trend, and a weakening trend indicates a market reversal.
When interpreting oscillator’s signals, you look at the specified high and low bands that fluctuate between the two extremes (support and resistance).
When the bands move towards the upper extreme, it suggests that the asset is overbought; it’s too expensive. On the contrary, the asset is oversold or too cheap if the oscillators approach the lower extreme.
Oscillators are used with other indicators and patterns to substantiate the signal. Remember, all forex indicators may provide a false signal; thus, using multi-indicator analysis is always advisable. Additionally, ask the community to verify your analysis or the signal before you trade it.
When you analyze and monitor the market using oscillators, you act on two market conditions: an overbought market and an oversold market.
An overbought market tells you that the price is too expensive. When this happens, it indicates that the bullish trend that drives the price up will reverse to bearish.
Why?
Because the market will hit the buyers' target, they lock in their profits. When this happens, the market will decline, presenting an entry opportunity for the bears.
On the flip side, an oversold market entails an extremely low price. This cheap asset price could be an entry point for the buyers and an exit point for sellers. When this happens, the market will have a bullish reversal.
Oscillators are great indicators that tell you about the momentum or strength of a trend. With this great feature, technical traders use these indicators when the market shows no clear breakout direction signal.
There are numerous oscillators you can use to monitor the condition of the market. Here are the two widely used oscillators by technical indicators.
| Oscillator Scale | Overbought Point | Oversold Point |
| 0% to -100% | 0% to -20% | -80% to -100% |
Founded by Larry Williams in 1966, Williams %R (full name: Williams Percent Range) checks the condition of the market by looking at its current closing price and high-to-low range over a 14.
William %R includes only a single line, making its signal easier to spot and interpret. But behind its simplicity are valuable insights into whether the market is at the best price to go long or short.
Additionally, this indicator is known to be responsive to price changes.
This presents opportunities to traders because it provides signals faster than other indicators of its type. However, this sensitivity boosts the risk of a false signal because it tends to react even to a simple market noise.
To calculate the oscillators using William %R, you should use this formula:
William %R = (Highest High – Close Price) / (Highest High – Lowest Low) x –100
| Oscillator Scale | Overbought Point | Oversold Point |
| 0% to 100% | 70% to 100% | 30% to 0% |
Developed by George Lane in the late 1950s, stochastics measures the currency pair’s closing price to the range it trades over a certain period.
According to Lane, technical analysts should consider the price speed or momentum when predicting the future price movement. Why? As per him, momentum changes before the price.
Thus, following the momentum allows you to position yourself early in the market before it changes direction. This means more pips for you when the market moves in your trade’s favor.
This type of oscillator suggests that the price will close at either the higher end or the lower end of the trading day – depending on the primary trend that starts the market.
Here’s the formula to calculate the stochastic oscillator:
Stochastic Oscillator (%K) = (Current Close – Lowest Low / Highest High – Lowest Low) x 100
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