(This is the 18th article in a series of articles on basic technical analysis originally published in Futures magazine.)

Previous articles in this series have emphasized the importance of identifying the trend in trying to trade successfully. Unfortunately, markets do not spend most of their time in trends or at least usually do not make it evident what the trend is as they chop back and forth from one period to the next.

What traders need to help them decipher market movements is an indicator that suggests the strength or weakness of the current price action compared to previous price action. Will the present pattern remain in place, or can some indicator detect that a market is undergoing some significant changes that could cause it to change direction?

One broad category of indicators that can give you a quick visual picture of what’s behind the price bars is the “oscillator.” Oscillators, in general, are based on comparing one number with another and showing the difference as a line chart or histogram. You could use volume or some other factor, but you are usually looking at two prices. The prices could show today’s price versus a previous day’s price, today’s price versus a moving average, a short-term moving average versus a long-term moving average or some other factor where a comparison of two numbers provides useful information.

The basic price oscillator uses two moving averages. In many respects, the result is similar to the Moving Average Convergence-Divergence indicator (November 2007 issue), but MACD is typically based on a 9-day smoothing average of the difference between 12- and 26-period moving averages; whereas, the price oscillator uses any two moving averages. The accompanying daily chart of 30-year Treasury Bond futures shows an oscillator based on 5- and 15-day moving averages.

Oscillators can be presented in several different ways. The first uses raw numbers that fluctuate above and below a zero line. The second calculates the numbers as percentage figures with all readings between 0 and 100. We will look only at the first method in this article; later articles will discuss the significance of the 0 - 100 scale for other indicators.

As the previous article on momentum suggested, you can just trade in the direction the oscillator is moving, or you can be long when it is above the zero line or short when it is below the zero line. Often, however, that clue comes late or is no clearer than the trend on the chart. What the oscillator really reveals is the pace of change in prices, whether the market is trading sideways, up or down.

A typical use of an oscillator is as an indicator that the increase or decrease in change between the two moving averages has reached an “overbought” or “oversold” condition that suggests the market is likely to return to “normal”. Note (on the hog chart) what happens when the oscillator slips below minus 1 in September and December: Prices start to turn up. When the oscillator exceeds plus 1 for the first time in October, prices turn down, but the uptrend continues to push the oscillator to plus 1 several times (arrows).

That illustrates one of the shortcomings of the oscillator indicator. You may set you oscillator alert at plus 1, based on previous price history, but that won’t keep the oscillator from moving up to 3 or 4 and certainly doesn’t mean that prices will not continue to move up. Most indicators share that weakness in strong trending markets, meaning that you cannot rely on them alone for a trading signal.

As with other aspects of technical analysis, you need to experiment with the parameters for oscillators to find those that give you the best view of what the market is trying to do. Once the oscillator gives you an idea of the tone of the market, you need to develop guidelines for entry and exit points and price targets to capture profits from market swings.

Next week: Analyzing a price bar