Oscillators, Importance and RSI

Introduction to Oscillators-

1) An oscillator is a technical analysis indicator that varies over time within a band (above and below a center line, or between set levels).

2) Oscillators are used to discover short-term overbought or oversold conditions.

3) The Oscillators are very useful in non trending markets, i.e when markets are in a range or in a consolidation phase. 

4) However, Oscillators can also be used in trending markets to determine short term market extremes called as overbought and oversold conditions.

5) The Oscillator can also warn that the trend is losing momentum before that situation becomes evident in the price action itself.

6) Hence, Oscillators can give important signals in range bound as well as trending markets, and Oscillators when combined with other analysis like trend lines breakout, chart pattern breakout, candlestick patterns, etc, it would give you a very good probability of success. 

For example, a stock is trading in oversold zone, that means now any time the stock can move up, but not sure when exactly can we expect an up move, and suddenly you see a particular candlestick pattern which is Bullish. So, that gives you an extra edge that OK now is the time to go long. So, Oscillators alone as a tool may not help you sometime, you have to use it in conjunction with various other tools to benefit out of it.

P.S - {Oversold means bahut jyada selling aah chuki hai, which means now buying can start, and Overbought means bahut jyada buying aah chuki hai, which means now selling will start, So whenever an indicator reaches its highest levels, it is said indicator is overbought and selling can come, and whenever an indicator reaches its lowest levels, it is said indicator is oversold and now buying can start soon}

THREE most Important uses of the Oscillators:

There are three situations when the oscillator is most useful. You will see that these three situations are common to most types of oscillators that are used:

1) The Oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its boundaries. The market is said to be Overbought when its near the upper extreme, and oversold when its near the lower extreme. 

2) A Divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.

3) The crossing of a zero (or midpoint ) line can give important trading signals in the direction of the price trend.

Different Types of Oscillators -- (Write only the one's asked in exam, if nothing is mentioned then you can write about oscillators in brief and explain 3 or 4 oscillators which you feel its easy):

1) Relative Strength Index-

• Relative strength index (RSI) was introduced in 1978 by J. Welles Wilder.
• It ranges between 0 and 100 and compares the magnitude of a stock's recent gains/losses with the stock's pricing action over a given time period (14-day RSI is most popular).
• RSI= 100 - 100/1+RS
• As with any other oscillator, buying and selling signals are generated when value of relative strength index crosses defined boundaries. If RSI closes above 70, value of security is overbought and selling signal is generated. If value crosses below 30, security is oversold and buying signal is generated.
• When stock is in up trend, then the overbought levels are 80 and oversold are around 40.
• When stock is in down trend, then the overbought levels are 60, and oversold are around 20.
• Divergence in RSI is very important to see :

1) CLASS 1 DIVERGENCE---YOU MAKE MORE MONEY

Here is the most basic example of how the price is increasing, and RSI is also increasing, but at the top when price is still moving higher, you see RSI losing strength and showing downside. Here is the time traders have to be cautious and sell all their long positions, as this can be end of an uptrend, and now the stock may come down soon. 

2) CLASS 2 DIVERGENCE--- YOU MAKE MEDIUM MONEY

Here is the second type of divergence, where the price is increasing, and the RSI is making double top pattern, as we can see in right hand side, when double top pattern on RSI breaks down, we can be sure that the stock is going to follow suit and fall in coming sessions. Sanjay sir refers this pattern as Class 2 divergence where you can make medium amount of money.

3) CLASS 3 DIVERGENCE--- YOU MAKE LESS MONEY AS COMPARED TO ABOVE 2

Hence this the last example of divergence shown, where Price remains flat and lose momentum, and RSI has already shown weakness, and we can expect prices to come down soon.

ALL THE 3 TYPES OF DIVERGENCE SHOWN ABOVE ARE TAKEN FOR OVERSOLD POSITIONS, AND ARE CALLED NEGATIVE DIVERGENCE, AS AFTER THIS, PRICES WOULD COME DOWN.

SIMILARLY ONE CAN SEE POSITIVE DIVERGENCE, AT OVERBOUGHT POSITIONS, WHICH MEANS WHERE PRICES WOULD FALL, AND YOU WILL SEE RSI STARTING TO RISE, WHICH WILL LEAD THE PRICES TO RISE SOON.

SO, CLEARLY RSI IS ONE OF THE BEST TOOLS TO ANALYSE THE STOCKS.