As part of technical analysis, oscillators are favored by forex traders for finding overbought and oversold levels, or places where to sell or buy from a technical point of view. Unfortunately, they are not working all the time in the sense that when the market is trending, an oscillator can stay in an overbought or oversold level much more than a trader can stay solvent.
Every trading platform offers a large range of oscillators, from the most popular ones (RSI – Relative Strength Index, CCI – Commodity Channel Index, DeMarker, MACD – Moving Average Convergence Divergence) to some oscillators that are little known and used, like Momentum, RVI – Relative Vigor Index, Williams’ Percent Range, etc. But the overall principle of trading, with an oscillator, is the same.
In a way, one can say that all oscillators are offering the same information to the forex trader, which, to some extent, is true. If this is the case, why are there so many options to pick from? Also, keep in mind that the oscillators listed above are only some of the ones offered as default by the broker.
There are other oscillators that can be used as well as custom made ones. The same principle applies to all oscillators, however; because it considers more candles from the past, the trading decision should stay with the oscillator and not with price.
It is a saying that between price and oscillator, one is lying, or giving a fake move. As a rule of thumb, the trader should always stay with the oscillator, and not with price, for the simple reason that it is considering more candles.
Traders that want to know more about the use of oscillators should know that they are not valued only for the ability to show overbought and oversold levels. Their true power comes when oscillators are combined with other trading theories.
The idea behind this strategy is to combine different trading theories with an oscillator interpretation and to use them both in the decision-making process. There is no other perfect example than using an oscillator with the Elliott Waves Theory.
The Elliott Waves Theory, along with other related articles, has been discussed here many times. The whole trading theory is based on the fact that the market is forming two types of waves; impulsive and corrective waves. Oscillators can be used in both circumstances, but the interpretation is different.
The RSI is the perfect oscillator to use in conjunction with the Elliott Waves Theory, for the simple reason that it is the most popular oscillator of them all. Moreover, it is showing overbought and oversold levels, exactly like the clear majority of oscillators, so what it is valid with the RSI should be valid with other oscillators as well.
Before starting, a clear distinction should be made between impulsive and corrective waves. RSI is used differently in these two instances.
With an impulsive move, there is a strong, powerful, extended wave that stands out of the crowd. Out of the five waves that make an impulsive move, typically the third wave is the one that extends.
This doesn’t matter for the oscillator as even if the impulsive move is a 1st wave extension or a 5th wave one, the interpretation should be the same. The idea behind using an oscillator with impulsive waves is to stay with the direction of the extended wave as much as possible.
Therefore, it is not recommended to sell in overbought areas or buy in oversold areas, as the impulsive move can extend way over the 161.8% minimum level and before you know it the account is blown away. In other words, it is not wise to sell an overbought move if the Elliott Wave analysis is pointing towards an impulsive move to follow.
The chart above shows the daily EURAUD cross that started a strong impulsive move. As any impulsive move, one wave needs to be extended, for all the rules to be respected.
In this case, the third wave is the extended wave, but the extension is far bigger than 161.8% when compared with the length of the first wave. Selling the overbought level (by the time the RSI reaches the 70 area) is a deadly mistake for the trading account as the whole time the third wave unfolds, the oscillator stays above 70.
A closer look shows the overbought level started shortly after the end of the second wave and going short there would have been a costly mistake. Only after a five-wave structure ends, the overbought level should be used as an indication to go short.
All in all, the RSI overbought and oversold levels should be ignored when an impulsive move is expected until the five-wave structure ends. Typically, the fifth wave will end up still being in an overbought area (or oversold in the case of a bearish move), but only then is it safe to initiate a new position given by the oscillator.