There are so many different approaches to trading, you could try a new one every day for the rest of your life and never run out of options. However, one that has been consistently popular, and consistently effective over the years has been momentum oscillator trading strategies.
Momentum Oscillators: What are they?
As the name suggests, these kinds of strategies are built around a specific kind of technical indicator, the momentum oscillator. These indicators measure market momentum, and while there are a variety of momentum oscillators in common use, they all are based on the principle that as momentum slows, there are fewer buyers and sellers for the current price, in other words, volume decreases. This is the opposite for momentum for when price/volume action increases.
As a leading indicator, the momentum oscillator generally shows future movements before price action starts to show any sign of a reversal. For this reason, these indicators can be incredibly useful in establishing potential changes in direction. To begin, we will discuss some common momentum oscillators and how they work. Although all these indicators fall under the momentum oscillator category, they do operate in different ways and should be used in slightly differently as a result.
Momentum Oscillators: Stochastic Oscillator
Developed in the late 1950’s, the stochastic is one of the longest standing modern momentum indicators and has been used at the core of successful strategies by tens of thousands of traders. It uses the closing price of the instrument as it relates to the high and low-price ranges for a given time period, usually set at 14 days. This indicator mainly focuses on the speed of change of price, also known as price momentum.
This unique indicator does two things:
- It has been found in general that the momentum of price movement will change before the price itself changes. Meaning this leading indicator can show where reversals are likely to happen.
- This oscillator can identify overbought and oversold levels, due to its rangebound nature. For the stochastic, overbought is considered anything at a value over 80, and oversold below 20.
Figure 1: Stochastic Oscillator with the indicator values for oversold and overbought.
An example of a practical trading use of this signal is the crossover strategy. This strategy uses the movement of the %K line to predict market behavior and can be surprisingly effective for such a simple approach.
For a buy signal: The %K line crosses upwards through the %D line while both lines are below the 20, oversold level.
Figure 2: Stock price vs. the Stochastic Oscillator with a buy signal based on the %K cross through the %D to the upside. The second buy signal originally showed a false positive but divergence confirmed the short-term bottom.
For a sell signal: The %K line must cross downwards through the %D line with both lines being above the 80, overbought level.
Figure 3: Stock price vs. Stochastic Oscillator with a sell signal based on the %K crossing the %D to the downside.
In both cases, the exit signal would be when the %K crosses back through the %D in the opposite direction to the entry signal.
In this case, a buy signal is occurring when the market is showing oversold conditions and price momentum is moving upwards. Both of these signals indicate an upward bias to the trend, the opposite applies for a sell signal. You may notice that although we are using a single indicator, it is actually giving two distinct signals for market direction. This known as trading oscillator divergence, in which the indicator is showing the opposite direction to the current trend, allowing you to see turning points in the market before they occur.
Momentum Oscillators: Relative Strength Index (RSI)
The Relative Strength Indicator, or RSI, is another indicator that measures the speed and change of price. It is calculated using the average gains and average losses in a given period, with the default timeframe being 14 days.
This lower indicator is used mostly to highlight overbought and oversold markets with a value over 70 being overbought and a value below 30 is oversold. At these levels, it is generally a sign that the market is about to change direction with a downtrend likely for an overbought market and an uptrend for an oversold one.
Figure 4: The RSI oversold vs. overbought with below 30 being oversold and above 70 is overbought. Notice in this image, the RSI never goes below 30. Sometimes users need to optimize the inputs (changing from the default timeframe from 14 to what matches the price action).
A classic use of RSI in a trade is the overbought/oversold signal being used to confirm a trend. For instance, if you are trading a downtrend, how do you know how long you should stick with the trend to maximize your trading profits?
On a large downtrend, RSI will stay around or below the 30 line, signaling an oversold market, and begin to rise when the trend is running out of steam. Likewise, in an uptrend, RSI may stay above or around the 70 mark to signal an overbought market and only change as the trend begins to fade.
Figure 5: This image shows how the change of the RSI input from 14 to 6 changes to match price action more accordingly. Moreover, notice how the RSI sometimes false signals too early and the Stochastic Oscillator confirms the buy signal when the %K crosses the %D.
Momentum Oscillators: Vortex Indicator (VI)
The Vortex Indicator is actually two oscillators that display both positive and negative trend movement. It uses highs and lows of the last two time periods, along with current highs and lows, to establish a positive trend indicator and a negative trend indicator.
The two indicators are displayed together with a green line representing positive movement and a red line for negative movement (these colors can change based on who is charting). The relationship between the two is used to assess bullish or bearish trends.
The crossover rules are as follows:
- Buy Signal – When the positive line crosses upwards through the negative line
- Sell Signal – When the positive line crosses downwards through the negative line
Figure 6: This image shows the Vortex Indicator confirming the uptrend with the VI+ crossing to the upside through the VI- followed by a 33% appreciation in price. It also shows, later on, that same uptrend breaking down and confirming a breakdown followed by a 10% drop in price.
Like the stochastic oscillator, trading strategies for the Vortex indicator tend to focus on crossover points. However, due to the more volatile nature of Vortex with false signals the norm, a slightly more involved approach is required.
However, like anything in the market, multiple indicators are generally needed for a true confirmation and will be explored later in this article.
Momentum Oscillators: Aroon Oscillator
The Aroon oscillator is based upon the Aroon up and down indicators and indicate trend reversals very similar to the Vortex Indicator. High values mean an uptrend and low values a downtrend over a given period. By default, the Aroon Oscillator uses a 25-day time period which is longer than some of the others mentioned as it is a slower reacting signal. There are two ways to show this oscillator, on its own or displayed with the original Aroon up and down indicators too, which gives a more comprehensive data set for decision making.
Figure 7: If this image looks similar, it should. The Aroon indicator confirms trends very similar to the Vortex Indicator.
This can be used to identify the beginnings of new trends and therefore aid in calling turning points for any instrument. When used in practice as part of a trading strategy, values above zero indicate an uptrend, and values below zero indicate a downtrend. The further the indicator is from the zero line, the stronger the trend. As with others here, oscillator divergence is one of the strongest signals in trading.
Momentum Oscillators: Williams % Range
Also known as the %R, the Williams % Range is another momentum oscillator identifying overbought and oversold levels. Named after its creator Larry Williams, the Williams % Range compares closing prices with the high and low of a given range. The default time period is 14 days,
Similar to the Relative Strength Index, this indicator displays a value of between 0 and 100 except the values are negative (0 to -100). This is well known for being a leading indicator of market reversals when the signal is above the -20 line (overbought) when it is below the -80 line (oversold). Compared to the Stochastic, which shows the relationship between close and lowest low, the Williams % Range compares the close with the highest high. In fact, the Stochastic Oscillator will produce the exact same line, they simply use a different scale.
Figure 8: The %R is known to signal early and should always be used with multiple indicators to confirm a trend. This indicator is one of the best lower indicators to find price divergence.
There are many ways to use the Williams % Range in practice, both on its own and in combination with other indicators. However, in its simplest form, the Williams % Range uses oscillator divergence to spot when current trends or ranges are about to fail and a new direction begins. As with other oscillators, because they lead the market it is like an early warning system for turning points.
When the value of the Williams % Range is above -20, it is signaling an overbought market but can also confirm momentum is increasing which can be just the start of an uptrend. If this occurs while the market itself is still consistently rising, then you have an opportunity to trade oscillator divergence to the downside before the next leg up. Similarly, if the market is showing consistent lower lows, a downtrend, with the Williams % Range below -80, this may be signaling momentum is decreasing and the price could continue down. Divergence can be a short-term signal for a possible dead cat bounce (short sellers covering to re-short the shares).
Figure 9: This image shows the Williams % Range becoming overbought quickly but then the price moving up substantially after. This is why it is important to use multiple indicators when looking for buy or sell signals.
Most trading strategies built around oscillators are built upon divergence. Oscillator divergence is the situation where the trend is going one way, and the oscillator is showing the reverse, and is the key to the indicators revealing where a direction change may occur. To trade oscillator divergence effectively we must be able to recognize when it occurs and what it is telling us.
Within technical analysis, divergence is often seen as one of the most powerful indicators of a price move. There are two instances of divergence:
- Positive Divergence – The market price is showing consecutive lower lows, a downtrend, but the oscillator is showing an upward trend.
- Negative Divergence – The market is showing consecutive higher highs, an uptrend, but the oscillator is showing a downward trend.
Figure 10: This chart shows MU with positive divergence on the daily candle price action vs. the Williams % Range. The price moved approximately 7% within 2 days of this signal.
Figure 11: This chart shows negative divergence on the SPY (S&P 500 ETF) with the RSI hitting lower highs but the price hitting higher highs. The result: a 2% drop over 5 days.
When looking at the strategies to make use of momentum oscillators, many use divergence as a leading signal which shows you what the market is likely to do soon, rather than so many indicators that only reflect what the market is currently doing. That ability to lead market price moves is why oscillator trading strategies can be so powerful.
Oscillator divergence, as we have shown, can be a fantastic tool, but to make the most out of it, incorporating the signal into a more complete trading strategy that offers ways to confirm direction changes or pinpoint entry and exit points is the most effective way to use it.
Figure 12: A depiction of how the momentum oscillators signal first (%R and RSI) and then trend reversal indicators (Stoch, Aroon, VI) confirm the move shown by the green and red circles in the middle of the trend. Notice the green and red circles moving to the right as you move down the indicator list.
Why should we take notice of momentum oscillators?
All these oscillators have proven incredibly useful when used with a good trading strategy. In some cases, that history of success stretches back over decades. However, as with everything in trading, it is all about a good strategy that is put into practice correctly and putting emotion to the side. There are thousands of oscillator trading strategies that have been created to use momentum oscillators, from basic ideas to complete commercial trading products. One cool thing about these is that some most effective ones are not overly complex and only require a general understanding of how the indicator works. A way to compare this is being able to drive a car without having to know how to put together the engine.
As we have discussed, momentum oscillators are great for identifying potential direction changes in the market, but no indicator is completely accurate. For instance, the RSI can give false signals when there are fast moves in the market which may be occurring due to systemic risk in the market in which technical indicators go out the door (Click here to learn more about this phenomenon). When combing multiple indicators, this can sometimes be avoided.
As there are thousands of indicators available of all types, why should you view momentum oscillators as more important? Not only have they a proven record of accuracy, but it is the people who use them that should make you take notice. Modern institutional trading (i.e. hedge funds/investment banks) has been transformed by computing. So much so, that a significant portion of their trading is carried out by computer algorithms which specifically look for oscillator divergence as one of their many signals they look for.
Please note that TrendSpider is a chart analysis system and does not offer trading or investing advice. Trading and investing are risky and involve a significant risk of losing your principal. Please see our full risk disclaimer on our website for more details. Always invest wisely.