As explained in the previous articles here on ForexGator.com, oscillators are technical indicators that are being placed on the actual chart. The idea of trading with oscillators is to look for differences between the move, the oscillator and the price.
Because the oscillator considers a period back in time, or a bigger number of candles when compared with the actual price that considers only one candle, the secret is to stay with the oscillator when making a trading decision. However, this is not always the right thing to do as, sometimes, the market is giving fake signals.
Elliott Waves Theory is based on interpreting the moves the market makes into impulsive and corrective ones. An impulsive move is called a five-wave structure, while a corrective wave is called a three-wave one.
Both moves though, can be traded with the help of an oscillator. As a rule of thumb, oscillators are showing overbought and oversold area or areas where traders are inclined to sell and buy a currency pair.
When market is traveling in an impulsive move, it is not wise to sell in overbought territory or buy in oversold territory as that is the area when the bulk of the move is being made. If a margin call is ever received, then most likely the oscillator stood in an overbought or oversold level more than the trader afforded.
All the ups and downs of trading an impulsive move with the help of an oscillator were covered already. However, market is spending most of the times in consolidation, with many currency pairs staying over 65% or more in corrective waves.
This means that traders are having bigger chances to succeed when trading corrective waves with the help of an oscillator. How do you know that the market is forming a corrective wave?
Elliott found that b-waves in any pattern are corrective waves. This means that trading a b-wave on a bigger time frame can be done more accurately with the help of an oscillator.
When compared with the way an impulsive move should be interpreting, in a corrective wave, we should look to sell in an overbought area and buy in an oversold area. Moreover, divergences are part of the whole process, as traders must stay with the diverged oscillator rather than with price.
The chart above shows the EURUSD currency pair on the daily time frame. The whole move from the moment the ECB (European Central Bank) started to cut rates can be seen, as the drop from 1.40 to almost parity was a classic impulsive move.
Below the actual chart, the RSI (Relative Strength Index) is plotted. Keep in mind the time frame, and the five-wave structure from the 1.40 until parity.
From the moment that the RSI is strong enough to reach 70 after a five-waves structure, we can assume a corrective wave or three-wave structure starts. This is when the oscillator can be used for taking a trade.
As explained above, an oscillator gives classic overbought and oversold signals whenever a correction is underway. In this case, it gives no less than five short trades and three long ones, all of them ending up in hefty profits.
From a contrarian trader’s point of view, the more time price spends in consolidation, the better. The RSI or any other oscillator, as a matter of fact, will continue showing profitable signals.
Divergences can be used as well. There is no divergence in the example above, but if any other spike would have made a new high or low, the RSI is not going to confirm that move, so it should be faded.
The big problem with corrections and oscillators is when corrections are not on the horizontal. The EURUSD example from above shows a horizontal correction, probably a flat with a double failure as a simple correction.
This makes trading the pattern quite easy. But what is to be done when the correction is a double combination, or, worse, a double zigzag?
In such a case, oscillators are not helping as divergences can appear multiple times and traders know that price can stay in a divergent mode more than a trader can. However, in the end, the overbought and oversold areas would still work, only one needs a bigger risk appetite.
Ideally, such patterns should be traded on lower time frames, even lower than the daily chart, like up to the maximum of the four-hour time frame. This way, things can be kept relatively under control and if price fades one or two divergences, there is still enough margin in the trading account to cover for the counter move.
The next article here on ForexGator.com will deal with different ways to trade with another wonderful oscillator, the RVI (Relative Vigor Index). There are three methods to consider, all of them offering profitable signals, so please check our next article.