Saturday, December 6, 2008

Oscillators: Bullish Divergence / Bearish Convergence

Reprinted from: http://www.alpari.co.uk/en/market-analysis-guide/technical-analysis/oscillators.html

Oscillators: Bullish Divergence / Bearish Convergence

Main principles of oscillators analysis

Oscillators are used to:

Determine the strength of the prevailing trend.
Determine when to open a position on a flat market.

To define if the trend is weak, use bullish divergence / bearish convergence.

Bullish divergence occurs when a new price high is not confirmed by a new oscillator high, i.e the next high is above the preceding one and the next oscillator high is lower than the preceding one. This implies that the uptrend is weak:

Bearish convergence occurs when a new bottom is not confirmed by a new oscillator bottom, i.e. every next bottom is lower than the preceding one and every next oscillator bottom is higher than the preceding one. This signals that the downtrend is weak:

Both bullish divergence and bearish convergence, however, show that it is better to refrain from opening a position against the weakening trend. Trend is valid until reversal signals appear.

It is important to be more careful with oscillators when the trend is strong; often false oscillator signals indicate the strength of the trend. If it is an uptrend then most of the time oscillators are in the overbought area, if it is a downtrend, they are in the oversold area. Overbought and oversold levels have to be defined for each indicator individually.

In the figures above Relative Strength Index (RSI) is used as an oscillator. If the indicator is above 70 then it is in the overbought area, if it is below 30 then it is in the oversold area.

When the trend is strong, the oscillator can be in the overbought (oversold) area for a long time and then it can exit the area but the trend will still be valid.

When the oscillator penetrates the overbought (oversold) area for the second time and then quickly goes back forming a bullish divergence/bearish convergence, there is a high chance that the trend will weaken.

In case, where the market is flat, it may be time to open a position once the oscillator leaves the overbought (oversold) area. Confirmation of the signal appears when the price is close to the upper (lower) border of the trading range.