Mastering Oscillator Signals and Volume Confirmation

Primary Uses of Trading Oscillators

Oscillators offer three primary functions for traders: (i) identifying overbought/oversold conditions; (ii) spotting divergences; and (iii) identifying crosses.

Overbought and Oversold Zones

• Overbought Zone: Defined as being above 0.01. Traders should look to sell at points that cross the horizontal line when a downward trend is indicated.
• Oversold Zone: Defined as being below -0.01. Traders should look to buy at points that cross the horizontal line when an upward trend is indicated.
• Zero Crosses: Additionally, sell during a downward trend when the indicator crosses the 0 line.

Identifying Bearish and Bullish Divergences

• Bearish Divergence: Occurs when the price reaches a new high, but the indicator makes a lower high.
• Bullish Divergence: Occurs when the price reaches a new low, but the indicator makes a higher low.

Volume Confirmation Strategies

Volume indicators and signals are usually not derived from volume itself, but from a change in volume. Below are seven rules (which serve as guides and allow for exceptions):

1. When prices are rising:
   • Increasing volume is impressive.
   • Decreasing volume is questionable.
2. When prices are declining.
3. When a price advance halts with high volume, it is potentially a top.
4. When a price decline halts with high volume, it is potentially a bottom.
5. High volume is necessary in an advance because it demonstrates active and aggressive interest in owning the stock. Conversely, high volume is not necessary in a decline.
6. Volume Spikes: These are most common at the beginning and the end of a trend.
7. High volume on a gap or breakout is usually a sign of a valid breakout. Although a breakout does not strictly require high volume, many analysts ignore breakouts that lack a volume spike.

On-Balance-Volume (OBV) Indicator Analysis

On-Balance-Volume (OBV) is calculated by adding the daily volume to the previous day's index if the price close was higher, and subtracting it if the price close was lower. If high volume is not confirming the price trend—specifically, if there is light volume in the price trend direction and heavy volume in the opposite direction—it suggests an impending reversal.

Interpreting OBV Trends

Observing the OBV line by itself is not helpful; instead, one must observe its trend and its action relative to price action. Additionally, when prices are in a trading range and the OBV breaks its own support or resistance, the break often indicates the direction in which the eventual price breakout will occur.