When one starts to study about trading and technical analysis, at some point they will learn about oscillators. They are called oscillators because their movement is limited between two values, usually zero and one hundred.
When the oscillator reaches zero, it typically means that the asset is oversold; and when it reaches one hundred, it is overbought.
It is very common that when someone discovers these tools (for example, the Relative Strength Index (RSI) and the Stochastics), the rookie trader thinks he should trade every time the indicator reaches a point.
For example, many traders buy when the RSI reaches 20 and sell when it reaches 80. If they are naïve enough, they may think they will not need to think anymore to make trading decisions.
Sadly, the market is not so easy.
After a time following that strategy, the trader will typically start to lose. I have been there. It is quite disappointing.
What is happening? Why does it not work if I am following the rules?
Well, oscillators alone may work for a while, but they are not enough. There are a couple of things you need to do to get the most out of them:
Use them in combination with other tools:
For example, you can analyse candlesticks following the Japanese method or look for other inklings from the chart like a double bottom or a head-and-shoulders formation. Others use them with volume… there is no magic way, but what is sure is that only the oscillator will not be enough in the long-term.
In this sense, a very useful way to use oscillators is to look for divergences between the price and the oscillator to trade. For example, if the graphic has a new top, but the RSI is marking a top lower than the previous one, you have a divergence between the asset and the oscillator that may be warning you that a correction is coming.
Adapt them to the market:
The reason why oscillators do not work in the long-term is because the market is continuously changing.
When you see the oscillator in the graphic, it is based on the most common settings. For example, the RSI usually uses a length of 14. If you study the cycles of your asset, you can find a better length for the RSI. For example, you can vary the length to check what is the length that would make the RSI signals coincide with the right moment to buy or sell.
That has a problem though. You may end up over-optimising the RSI for the past movements, and what should really worry you is the future. So from here, just take the idea that the predefined setting for the oscillators does not have to be the best.
Another thing you can do is check the levels of the oscillator when the asset is in a bull trend, sideways, and bearish trend.
We are sure that the tops of the RSI are significantly lower when they are in a bearish trend than when in a bullish. This means that if after a correction, in the next top, the RSI reaches the level that it usually reaches in a bearish trend, but it does not touch the level it usually has in the bullish trend, a bigger correction may be waiting behind the door.