the chart and drawhorizontal lines along its upper and lower boundaries. These lineswill have to be adjusted periodically, especially after importanttrend changes have occurred. But it is the simplest and probablythe most effective way of identifying the outer extremities. (SeeFigures 10.3 and 10.4.) 
{TR1600) Treasury Bonds 1600
 
 
 
10 Day Momentum
 
 
 
 
 
 
 
Figure 10.3 By visual inspection, the analyst can find the upper and lowermomentum boundaries that are suitable for each market (see horizontal lines).
 
hov15793 {TR1600) Treasury Bonds 1600
i
 
 
 
 
 
 
 
 
Figure 10.4 A 13 week momentum line on a weekly chart of TreasuryBonds. The arrows mark the turning points from momentum extremes. Themomentum line changed direction before the price at each major turn (points1, 2, and 3).234 Chapter 10
 
MEASURING RATE OFCHANGE (ROC)
To measure the rate of change, a ratio is constructed of the mostrecent closing price to a price a certain number of days in the past.To construct a 10 day rate of change oscillator, the latest closingprice is divided by the close 10 days ago. The formula is as follows:
Rate of change = 100 (V/Vx)
where V is the latest close and Vx is the closing price x days ago.
In this case, the 100 line becomes the midpoint line. Ifthe latest price is higher than the price 10 days ago (prices arerising), the resulting rate of change value will be above 100. Ifthe last close is below 10 days ago, the ratio would be below100. (Charting software sometimes uses variations of the pre-ceding formulas for momentum and rate of change. While theconstruction techniques may vary, the interpretation remainsthe same.)
CONSTRUCTING AN OSCILLATORUSING TWO MOVING AVERAGES
Chapter 9 discussed two moving averages being used to generatebuy and sell signals. The crossing of the shorter average above orbelow the longer average registered buy and sell signals, respec-tively. It was mentioned at that time that these dual moving aver-age combinations could also be used to construct oscillator charts.This can be done by plotting the difference between the two aver-ages as a histogram. These histogram bars appear as a plus orminus value around a centered zero line. This type of oscillatorhas three uses:
1. To help spot divergences.
2. To help identify short term variations from the long termtrend, when the shorter average moves too far above orbelow the longer average.Oscillators and Contrary Opinion 235eee ee ,) SII
3. To pinpoint the crossings of the two moving averages,which occur when the oscillator crosses the zero line.
The shorter average is divided by the longer. In both cases,however, the shorter average oscillates around the longer average,which is in effect the zero line. If the shorter average is above thelonger, the oscillator would be positive. A negative reading wouldbe present if the shorter average were under the longer. (SeeFigures 10.5-10.7.)
When the two moving average lines move too far apart,a market extreme is created calling for a pause in the trend.(See Figure 10.6.) Very often, the trend remains stalled untilthe shorter average line moves back to the longer. When the
   
 
 
("SPX) S&P 500 Stock index
 
| | Moving Average Difference | | | | |
vail Ili Lg, wlll ft IINLUIa aes
er eeFigure 10.5 The histogram lines measure the difference between the two
moving averages. Crossing above and below the zero line give buy and sellsignals (see arrows). Notice that the histogram turns well before the actualsignals (see circles).
      
 
 
 
 
    236 Chapter 10
 
(*SPX) S&P 500 Stock Index
 
 
Moving Average Difference
“SAT Team rr wag Vioeetioken © Groags Rsssarch, is THT
 
 
 
 
Figure 10.6 A histogram measuring the difference between the 10 and50 day averages. The histogram always turns well before the zero linecrossover. In an uptrend, the histogram will find support at the zero line andturn up again (third arrow).
shorter line approaches the longer, a critical point is reached. Inan uptrend, for example, the shorter line dips back to the longeraverage, but should bounce off it. This usually represents an idealbuying area. It’s much like the testing of an up trendline. If theshorter average crosses below the longer average, however, a trendreversal is signaled.
In a downtrend, a rise in the shorter average to the longerusually represents an ideal selling area unless the longer line iscrossed, in which case a trend reversal signal would be registered.The relationships between the two averages can be used, there-fore, not only as an excellent trend-following system, but also tohelp identify short term overbought and oversold conditions.Oscillators and Contrary Opinion 237
 
3/10/95 (*SOX) Phix Semiconductor Index
 
Weekly Bar Chart
~"""'40 Week Average
 
 
di Th gil
Figure 10.7 A histogram plotting the difference between 2 weekly aver-ages. The histogram turned in the direction of the new price trend weeksbefore the actual zero line crossings on the histogram. Notice how easily theoverbought and oversold levels are seen.
 
 
 
 
 
— 7A 2 0a a ee]
 
 
COMMODITY CHANNEL INDEX
It is possible to normalize an oscillator by dividing the values bya constant divisor. In the construction of his CommodityChannel Index (CCI), Donald R. Lambert compares the currentprice with a moving average over a selected time span—usually 20days. He then normalizes the oscillator values by using a divisorbased on mean deviation. As a result, the CCI fluctuates in a con-stant range from +100 on the upside to -100 on the downside.Lambert recommended long positions in those markets with val-ues over +100. Markets with CCI values below -100 were candi-dates for short sales.238 Chapter 10
 
It seems, however, that most chartists use CCI simply as anoverbought/oversold oscillator. Used in that fashion readings over+100 are considered overbought and under -100 are oversold.While the Commodity Channel Index was originally developedfor commodities, it is also used for trading stock index futures andoptions like the S&P 100 (OEX). Although 20 days is the commondefault value for CCI, the user can vary the number to adjust itssensitivity. (See Figures 10.8 and 10.9.)
 
fan 7197 (TR1600) Treasury Bonds 1600
 
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Commodity Channet Index
 
 
 
 
 
 
 
 
 
Figure 10.8 A 20 day Commodity Channel Index. The original intent ofthis indicator was to buy moves above +100 and sell moves below -100 asshown here.Oscillators and Contrary Opinion 239
 
44/41/97 (*OEX) S&P 100 Stock Index 03/05/98}it Nt}
 
pu
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Commodity Channel Index
 
 
 
 
 
 
 
Figure 10.9 = The Commodity Channel Index can be used for stock index-es like this one and can also be used like any other oscillator to measuremarket extremes. Notice that the CCI turns before prices at each top and bot-tom. The default length is 20 days.
THE RELATIVE STRENGTHINDEX (RSI)
The RSI was developed by J. Welles Wilder, Jr. and presented in his1978 book, New Concepts in Technical Trading Systems. We're onlygoing to cover the main points here. A reading of the originalwork by Wilder himself is recommended for a more in-depthtreatment. Because this particular oscillator is so popular amongtraders, we'll use it to demonstrate most of the principles of oscil-lator analysis.
As Wilder points out, one of the two major problems inconstructing a momentum line (using price differences) is theerratic movement often caused by sharp changes in the valuesbeing dropped off. A sharp advance or a decline 10 days ago (inthe case of a 10 day momentum line) can cause sudden shifts in240 Chapter 10
 
the momentum line even if the current prices show little change.Some smoothing is therefore necessary to minimize these distor-tions. The second problem is that there is the need for a constantrange for comparison purposes. The RSI formula not only pro-vides the necessary smoothing, but also solves the latter problemby creating a constant vertical range of 0 to 100.
The term “relative strength,” incidentally, is a misnomerand often causes confusion among those more familiar withthat term as it is used in stock market analysis. Relative strengthgenerally means a ratio line comparing two different entities. Aratio of a stock or industry group to the S&P 500 Index is oneway of gauging the relative strength of different stocks or indus-try groups against one objective benchmark. We’ll show youlater in the book how useful relative strength or ratio analysis canbe. Wilder’s Relative Strength Index doesn’t really measure thetelative strength between different entities and, in that sense,the name is somewhat misleading. The RSI, however, does solvethe problem of erratic movement and the need for a constantupper and lower boundary. The actual formula is calculated asfollows:
_ 100RSI = 100 - 75s
S= Average of x days’ up closesAverage of x days’ down closes
Fourteen days are used in the calculation; 14 weeks areused for weekly charts. To find the average up value, add the totalpoints gained on up days during the 14 days and divide that totalby 14. To find the average down value, add the total number ofpoints lost during the down days and divide that total by 14.Relative strength (RS) is then determined by dividing the up aver-age by the down average. That RS value is then inserted into theformula for RSI]. The number of days can be varied by simplychanging the value of x.
Wilder originally employed a 14 day period. The shorter thetime period, the more sensitive the oscillator becomes and the wider itsamplitude. RSI works best when its fluctuations reach the upperOscillators and Contrary Opinion 241
and lower extremes. Therefore, if the user is trading on a very shortterm basis and wants the oscillator swings to be more pronounced,the time period can be shortened. The time period is lengthenedto make the oscillator smoother and narrower in amplitude. Theamplitude in the 9 day oscillator is therefore greater than the orig-inal 14 day. While 9 and 14 day spans are the most common val-ues used, technicians experiment with other periods. Some useshorter lengths, such as 5 or 7 days, to increase the volatility of theRSI line. Others use 21 or 28 days to smooth out the RSI signals.(See Figures 10.10 and 10.11.)
 
(*OEX) S&P 100 Stock Index
 
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Relative Strength index (RSI) - 14 Dey
 
 
 
 
 
 
 
Figure 10.10 The 14 day Relative Strength Index becomes overboughtover 70 and oversold below 30. This chart shows the S&P 100 being oversoldin October and overbought during February.242 Chapter 10
("OEX) S&P 100 Stock Index
Relative Strength Index (RSI) - 14 Day
 
 
 
Relative Strength Index (RSI) - 7 Day
 
 
 
 
 
 
 
Figure 10.11 The amplitude of the RSI line can be widened by shorten-ing the time period. Notice that the 7 day RSI reaches the outer extremesmore frequently than the 14 day RSI. That makes the 7 day RSI more usefulto short term traders.
Interpreting RSI
RSI is plotted on a vertical scale of 0 to 100. Movements above70 are considered overbought, while an oversold conditionwould be a move under 30. Because of shifting that takes placein bull and bear markets, the 80 level usually becomes the over-bought level in bull markets and the 20 level the oversold levelin bear markets.
“Failure swings,” as Wilder calls them, occur when the RSIis above 70 or under 30. A top failure swing occurs when a peak inthe RSI (over 70) fails to exceed a previous peak in an uptrend, fol-lowed by a downside break of a previous trough. A bottom failureswing occurs when the RSI is in a downtrend (under 30), fails toset a new low, and then proceeds to exceed a previous peak. (SeeFigures 10.12a-b.) 
03126197 (DWU) Dow Utitties
Relative Strength Index (RSI) - 9 Day
 
| | | , ~ Foe Sing
 
 
 
 
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Figure 10.12a A bottom failure swing in the RSI line. The second RSI trough(point 2) is higher than the first (point 1) while it is below 30 and prices are stillfalling. The upside penetration of the RSI peak (point 3) signals a bottom.
 
 
 
 
beri9re7 (‘DWT X) Dow TransportationRelative Strength Index (RSI) - 9 Day
 
 
 
 
 
 
 
 
Figure 10.12b A top failure swing. The second peak (2) is lower thanthe first (1) while the RSI line is over 70 and prices are still rallying. Thebreak by the RSI line below the middle trough (point 3) signals the top.244 Chapter 10
Divergence between the RSI and the price line, when theRSI is above 70 or below 30, is a serious warning that should beheeded. Wilder himself considers divergence “the single mostindicative characteristic of the Relative Strength Index” [Wilder,p. 70].
Trendline analysis can be employed to detect changes inthe trend of the RSI. Moving averages can also be used for thesame purpose. (See Figure 10.13.)
 
(*DWU) Dow Utilities 07/18/97
 
 
 
 
 
 
 
Figure 10.13 Trendlines work very effectively on the RSI line. The breakingof the two RSI trendlines gave timely buy and sell signals on this chart (seearrows).
In my own personal experience with the RSI oscillator, itsgreatest value lies in failure swings or divergences that occurwhen the RSI is over 70 or under 30. Let's clarify another impor-tant point on the use of oscillators. Any strong trend, either upor down, usually produces an extreme oscillator reading beforeOscillators and Contrary Opinion 245
 
too long. In such cases, claims that a market is overbought oroversold are usually premature and can lead to an early exitfrom a profitable trend. In strong uptrends, overbought marketscan stay overbought for some time. Just because the oscillatorhas moved into the upper region is not reason enough to liqui-date a long position (or, even worse, short into the stronguptrend).
The first move into the overbought or oversold region isusually just a warning. The signal to pay close attention to is thesecond move by the oscillator into the danger zone. If the secondmove fails to confirm the price move into new highs or new lows(forming a double top or bottom on the oscillator), a possibledivergence exists. At that point, some defensive action can betaken to protect existing positions. If the oscillator moves in theopposite direction, breaking a previous high or low, then a diver-gence or failure swing is confirmed.
The 50 level is the RSI midpoint value, and will often actas support during pullbacks and resistance during bounces.Some traders treat RSI crossings above and below the 50 level asbuying and selling signals respectively.
USING THE 70 AND 30 LINES TOGENERATE SIGNALS
Horizontal lines appear on the oscillator chart at the 70 and 30values. Traders often use those lines to generate buy and sell sig-nals, We already know that a move under 30 warns of an over-sold condition. Suppose the trader thinks a market is about tobottom and is looking for a buying opportunity. He or shewatches the oscillator dip under 30. Some type of divergence ordouble bottom may develop in the oscillator in that oversoldregion. A crossing back above the 30 line at that point is takenby many traders as a confirmation that the trend in the oscilla-tor has turned up. Accordingly, in an overbought market, acrossing back under the 70 line can often be used as a sell signal.(See Figure 10.14.)246 Chapter 10
(*DWU) Dow Utilities
Monthly Bar Chart
 
Relative Strength Index (RSI) - 9 Month
 
 
 
 
Ya 1s 96 77 oe Te bo m1 b2 bs ms 65 bs by be Wo bo br bc bo we bs bo U7TAT Tein Pita wg Tedeion © Crna Rasen PET
 
Figure 10.14 The RSI oscillator can be used on monthly charts. Notice thetwo major oversold buy signals in 1974 and 1994. The overbought peaks inthe RSI line did a pretty good job of pinpointing important tops in the utilities.
STOCHASTICS (K%D)
The Stochastic oscillator was popularized by George Lane (presi-dent of Investment Educators, Inc., Watseka, IL). It is based on theobservation that as prices increase, closing prices tend to be clos-er to the upper end of the price range. Conversely, in downtrends,the closing price tends to be near the lower end of the range. Twolines are used in the Stochastic Process—the %K line and the %Dline. The %D line is the more important and is the one that pro-vides the major signals.
The intent is to determine where the most recent closing priceis in relation to the price range for a chosen time period. Fourteen isthe most common period used for this oscillator. To determine the Kline, which is the more sensitive of the two, the formula is:
%K = 100 [(C - L14) / (H14 - L14)]Oscillators and Contrary Opinion 247
where C is the latest close, L14 is the lowest low for the last 14periods, and H14 is the highest high for the same 14 periods (14periods can refer to days, weeks, or months).
The formula simply measures, on a percentage basis of 0 to100, where the closing price is in relation to the total price rangefor a selected time period. A very high reading (over 80) would putthe closing price near the top of the range, while a low reading(under 20) near the bottom of the range.
The second line (%D) is a 3 period moving average of the%K line. This formula produces a version called fast stochastics.By taking another 3 period average of %D, a smoother versioncalled slow stochastics is computed. Most traders use the slow sto-chastics because of its more reliable signals.*
These formulas produce two lines that oscillate between avertical scale from 0 to 100. The K line is a faster line, while the Dline is a slower line. The major signal to watch for is a divergencebetween the D line and the price of the underlying market whenthe D line is in an overbought or oversold area. The upper andlower extremes are the 80 and 20 values. (See Figure 10.15.)
A bearish divergence occurs when the D line is over 80 andforms two declining peaks while prices continue to move higher.A bullish divergence is present when the D line is under 20 andforms two rising bottoms while prices continue to move lower.Assuming all of these factors are in place, the actual buy or sell sig-nal is triggered when the faster K line crosses the slower D line.
There are other refinements in the use of Stochastics, butthis explanation covers the more essential points. Despite the high-er level of sophistication, the basic oscillator interpretation remainsthe same. An alert or set-up is present when the %D line is in anextreme area and diverging from the price action. The actual signaltakes place when the D line is crossed by the faster K line.
The Stochastic oscillator can be used on weekly and month-ly charts for longer range perspective. It can also be used effective-ly on intraday charts for shorter term trading. (See Figure 10.16.)
One way to combine daily and weekly stochastics is to useweekly signals to determine market direction and daily signals fortiming. It’s also a good idea to combine stochastics with RSI. (SeeFigure 10.17.)
* The second smoothing produces 3 lines. Fast stochastics uses the first 2 lines.Slow stochastics uses the last 2 lines. 
02/07/97 (TR1600) Treasury Bonds 1600 03/13/98
Weekly Bar Chart | ‘a4
     
   
i t 41286i"1|hy a 40012i
   
 
 
 
 
 
 
 
Figure 10.15 The down arrows show two sell signals which occur whenthe faster %K line crosses below the slower %D line from above the 80 level.The %K line crossing above the %D line below 20 is a buy signal (up arrow).
 
* (TR1600) Treasury Bonds 1600
Weekly Bar Chart
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Stochastics - 14 Week
 
 
 
 
 
 
 
Figure 10.16 Turns in the 14 week stochastics from above 80 and below20 did a nice job of anticipating major turns in the Treasury Bond market.Stochastics charts can be constructed for 14 days, 14 weeks, or 14 months.Oscillators and Contrary Opinion 249
 
borezres (TR1600) Treasury Bonds 1600Weekly Line Chart
 
 
RSI - 14 Week
 
 
 
sb 88
 
Stochastics - 14 Week
 
SPT
 
 
 
 
 
 
Figure 10.17 A comparison of the 14 week RSI and stochastics. The RSIline is less volatile and reaches extremes less frequently than stochastics. Thebest signals occur when both oscillators are in overbought or oversold territory.
LARRY WILLIAMS %R
Larry Williams %R is based on a similar concept of measuring thelatest close in relation to its price range over a given number ofdays. Today’s close is subtracted from the price high of the rangefor a given number of days and that difference is divided by thetotal range for the same period. The concepts already discussed foroscillator interpretation are applied to %R as well, with the mainfactors being the presence of divergences in overbought or over-sold areas. (See Figure 10.18.) Since %R is subtracted from thehigh, it looks like an upside down stochastics. To correct that,charting packages plot an inverted version of %R.250 Chapter 10
 
(SPX) S&P 500 Stock Index 03/05/98
 
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Figure 10.18 Larry Williams %R oscillator is used in the same fashionas other oscillators. Readings over 80 or under 20 identify market extremes.
Choice of Time Period Tied to Cycles
Oscillator lengths can be tied to underlying market cycles. A timeperiod of !/, the cycle length is used. Popular time inputs are 5, 10,and 20 days based on calendar day periods of 14, 28, and 56 days.Wilder’s RSI uses 14 days, which is half of 28. In the previouschapter, we discussed some reasons why the numbers 5, 10, and20 keep cropping up in moving average and oscillator formula-tions, so we won't repeat them here. Suffice it to mention herethat 28 calendar days (20 trading days) represent an importantdominant monthly trading cycle and that the other numbers arerelated harmonically to that monthly cycle. The popularity of the10 day momentum and the 14 day RSI lengths are based largelyon the 28 day trading cycle and measure /, of the value of thatdominant trading cycle. We'll come back to the importance ofcycles in Chapter 14.Oscillators and Contrary Opinion 251
THE IMPORTANCE OF TREND
In this chapter, we've discussed the use of the oscillator in marketanalysis to help determine near term overbought and oversoldconditions, and to alert traders to possible divergences. We start-ed with the momentum line. We discussed another way to mea-sure rates of change (ROC) by using price ratios instead of differ-ences. We then showed how two moving averages could be com-pared to spot short term extremes and crossovers. Finally, welooked at RSI and Stochastics and considered how oscillatorsshould be synchronized with cycles.
Divergence analysis provides us with the oscillator’s greatestvalue. However, the reader is cautioned against placing too muchimportance on divergence analysis to the point where basic trendanalysis is either ignored or overlooked. Most oscillator buy signalswork best in uptrends and oscillator sell signals are most profitablein downtrends. The place to start your market analysis is always bydetermining the general trend of the market. If the trend is up,then a buying strategy is called for. Oscillators can then be used tohelp time market entry. Buy when the market is oversold in anuptrend. Sell short when the market is overbought in a downtrend.Or, buy when the momentum oscillator crosses back above thezero line when the major trend is bullish and sell a crossing underthe zero line in a bear market.
The importance of trading in the direction of the majortrend cannot be overstated. The danger in placing too much impor-tance on oscillators by themselves is the temptation to use diver-gence as an excuse to initiate trades contrary to the general trend.This action generally proves a costly and painful exercise. The oscil-lator, as useful as it is, is just one tool among many others and mustalways be used as an aid, not a substitute, for basic trend analysis.
WHEN OSCILLATORS AREMOST USEFUL
There are times when oscillators are more useful than at others.During choppy market periods, as prices move sideways for severalweeks or months, oscillators track the price movement very close-252 Chapter 10
 
ly. The peaks and troughs on the price chart coincide almost exact-ly with the peaks and troughs on the oscillator. Because both priceand oscillator are moving sideways, they look very much alike. Atsome point, however, a price breakout occurs and a new uptrend ordowntrend begins. By its very nature, the oscillator is already in anextreme position just as the breakout is taking place. If the break-out is to the upside, the oscillator is already overbought. An over-sold reading usually accompanies a downside breakout. The traderis faced with a dilemma. Should he or she buy the bullish breakoutin the face of an overbought oscillator reading? Should the down-side breakout be sold into an oversold market?
In such cases, the oscillator is best ignored for the timebeing and the position taken. The reason for this is that in theearly stages of a new trend, following an important breakout,oscillators often reach extremes very quickly and stay there forawhile. Basic trend analysis should be the main consideration atsuch times, with oscillators given a lesser role. Later on, as thetrend begins to mature, the oscillator should be given greaterweight. (We’ll see in Chapter 13, that the fifth and final wave inElliott Wave analysis is often confirmed by bearish oscillatordivergences.) Many dynamic bull moves have been missed bytraders who saw the major trend signal, but decided to wait fortheir oscillators to move into an oversold condition before buy-ing. To summarize, give less attention to the oscillator in the earlystages of an important move, but pay close attention to its signalsas the move reaches maturity.
MOVING AVERAGE CONVERGENCE/DIVERGENCE (MACD)
We mentioned in the previous chapter an oscillator techniquethat uses 2 exponential moving averages and here it is. TheMoving Average Convergence/Divergence indicator, or simplyMACD, was developed by Gerald Appel. What makes this indica-tor so useful is that it combines some of the oscillator principleswe've already explained with a dual moving average crossoverapproach. You'll see only two lines on your computer screenalthough three lines are actually used in its calculation. The fasterOscillators and Contrary Opinion 253
 
line (called the MACD line) is the difference between two expo-nentially smoothed moving averages of closing prices (usually thelast 12 and 26 days or weeks). The slower line (called the signalline) is usually a 9 period exponentially smoothed average of theMACD line. Appel originally recommended one set of numbersfor buy signals and another for sell signals. Most traders, howev-er, utilize the default values of 12, 26, and 9 in all instances. Thatwould include daily and weekly values. (See Figure 10.19a.)
The actual buy and sell signals are given when the twolines cross. A crossing by the faster MACD line above the slowersignal line is a buy signal. A crossing by the faster line below theslower is a sell signal. In that sense, MACD resembles a dual mov-ing average crossover method. However, the MACD values alsofluctuate above and below a zero line. That’s where it begins toresemble an oscillator. An overbought condition is present when
 
psr2197 (OTC) Nasdaq Composite Index
anml " ‘| | «flut iw |Pye I i, M yf I
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Figure 10.19a The Moving Average Convergence Divergence systemshows two lines. A signal is given when the faster MACD line crosses theslower signal line. The arrows show five trading signals on this chart of theNasdag Composite Index.254 Chapter 10
the lines are too far above the zero line.