RSI MACD Stochastic: which oscillator to use, and when

RSI, Stochastic, MACD are the big three.

Some people will swear by one, while regarding the others as unreliable.

But they each have strengths and weaknesses.

Finding the right one for your style of trading may take a bit of trial and error, but here I’ll show you under the hood what each of them actually DO (don’t worry – we won’t go into the maths) … and where they really flex their indicator muscles.

Why we use oscillators

Before risking our capital, we want to know if any market move has some power behind it, and we look to oscillators to give us a clue about momentum.

They do this by telling us how fast a price is changing … how far it’s changing … and how extreme it is …

This gives us insight into whether a new move is worth jumping on board … or whether an old move is running out of steam.

I’m going to look at three big players in the oscillator armory, to see which are best in different situations …

MACD under the hood

The macD indicator is what happens when you love moving averages so much, you make a moving average of a moving average of a moving average … and it carries on like one of those Escher pictures …

What we actually end up with is an oscillator line measuring the difference between two exponential moving averages (the defaults are 12 and 26), then a signal line, which is a moving average (typically 9 periods) of the MACD line. Plus, we have a histogram, which visually shows us the difference between the two lines.

If that’s lost you, here’s a visual …

Essentially, the MACD is just regurgitating data from two moving averages. However, it provides a very useful tool to measure how steeply those moving averages are moving, and how they are changing in relation to each other.

Note how, in the image above, the crossover on the MACD (marked in pink) warns us of the direction change significantly before the moving averages on the chart crossover (marked in yellow).

Because they are based around moving averages, the MACD has the downside of being laggy compared to other oscillators. This isn’t necessarily a bad thing – lagging indicators tend to be more reliable. It just depends on what you need.

RSI under the hood

The RSI indicator measures recent price changes and is calculated by comparing the average upward price change against the average downward price change over a set number of periods.

The fewer the periods it’s measured against, the jumpier the indicator will be. The default is 14 periods.

So, if your average price gain is significantly more than the average loss over the last 14 periods, you’ll get a high reading on the RSI (the range is 0–100).

If you get bigger average losses than gains over the last 14 periods, then your RSI reading will be low.

And if your average wins and losses are equal over the last 14 periods, you’ll get an RSI reading bang on 50.

The maths behind the RSI is really quite basic. Again, it’s about the insight it gives us when we’re staring at a jumble of candlesticks on our charts.

The RSI is a pretty steady hand as indicators go – it doesn’t swerve into overbought/oversold territory very easily. So, when it does move, it’s generally worth listening to.

And by having just a single line, it’s an easy way to spot divergence – as in the glaring example shown above.

Stochastics under the hood

The Stochastics calculation is different again.

The Stochastic line (called %K) is all about the closing price of the last candle, and how it compares to the range of the previous candles within the time period (14 periods is the default).

The second line on the indicator is called %D, and is a 3-period moving average of %K.

The theory behind the Stochastic is that a rising price will spend more time close to a recent high, while a falling price will spend more time close to its recent low.

The Stochastic indicator is a lot choppier than the RSI or MACD, swinging from oversold to overbought and back again in the space of a few candles. This is a high-drama indicator.

That can be helpful if you want more signals … but will also mean more false moves.

How to pick the right oscillator for the job

While the general direction of these oscillators and the peaks and troughs look quite similar … they are by no means the same.

Here’s a glimpse of a chart showing all three oscillators at work …

Think about what you NEED from your indicator …

• Look at your other indicators – look for an oscillator that’s giving NEW information, not just repeating what you already have.
• Oscillators are often used for confirmation. Do you want reassurance that momentum is building into the trend?
• Are you looking for accurate timing? Stochastic can give pin-point accuracy on entries, but must be combined with cautious indicators, otherwise you’ll be jumping into the market at every twist and turn.
• Don’t discount the MACD histogram – this is a useful measure of how the MACD is behaving against its moving average.
• Put the oscillators onto your charts and back test ­– see which ones will give you the best signals for your trading style.

And check out these two strategies, which demonstrate some of my favourite ways to use oscillators …

The Double Trigger Line Strategy here has a neat trick of looking backwards at the Stochastic, so we get confirmation from it, but we don’t jump into the market on it. (It also uses the MACD.)

Easy Trigger Line Trades

The Double MACD Pimp Out Strategy actually uses JUST moving averages and MACD. You could argue that it’s an over-reliance on trend indicators, but when it works this neatly, it’s hard to dispute.

Indicator hack #2: the Double MACD pimp out

Let me know what you think.

To enjoy more content and get it faster Follow @TradersBulletin