Solving a crucial FTSE mystery

Oscillators measure market momentum, like a fan that weaves back and forth within a prescribed ambit. These technical indicators function like first-derivative rates of change, as they plot conditions where financial assets are overbought or oversold.

Investors, who are always prone to herd behavior, tend to jump into assets that have been performing well. Soon others join in with funds providing fresh fuel to keep a trade popular. Finally, particularly if prices have risen exceptionally quickly, profit-taking ensues. Vice versa, in oversold situations, “traders dump stocks without much rational thought,” says Guy Ortmann, senior technical analyst at Scarsdale Equities. “Eventually, selling gets exhausted and bids enter the market.”

With a host of oscillators available, it is advisable to become familiar with one or two, according to your particular time horizons and risk preferences. Would you rather be early, with more potential upside, or later, with more solid confirmation? But add too many on your screen, and they soon become redundant.

Some oscillators are bounded within a predetermined channel, and these work ideally in sideways markets. Others, which have no lower and upper limits, can be applied in environments with discernible trends. In either case, Ari Wald, technical analyst at Brown Brothers Harriman, asks himself three questions when he examines an oscillator: is it in overbought or oversold territory, does it confirm or diverge from the concurrent behaviour of asset prices, and is the reading weak or strong – that is, entrenched in upper or lower ranges?

Mr Ortmann likes to use a stochastic oscillator, which looks at a series of an asset’s closing prices as a percentage of its price range over a period. Stochastics’ parameters extend from 0 to 100, but generally travel between 20 and 80 during normal times. For example, Mr Ortmann explains, “when something has been closing near the top of its range for a while, and suddenly finishes lower, strength must be diminishing as sellers gain influence and take control. Exhausted buyers can no longer drive prices to new highs.” Mr Ortmann prefers to use stochastics as a verification (rather than a leading indicator), while he simultaneously takes other technical indicators into account.

As another bounded oscillator, Mr Wald has found the relative strength index (RSI), especially helpful over recent years. The FTSE is illustrative. Last summer, while the FTSE sold off in August, the RSI dipped to oversold levels near 20. The RSI then zigzagged for the next couple of months. But going into October it was reaching higher lows, while the FTSE price plummeted. “That positive divergence was your sign to buy, which would have set you up for a great rally into this year,” says Mr Wald.