Contrarians and Oscillators

THE BREAKDOWN - A little insight into oscillators. My oscillator of choice is an RSI. Oscillators scale between 0-100 and will give you an indication of how extended a market is based on its reading between 0-100. An extended market to the topside will show readings above 70, while an extended market to the downside will show readings below 30. The way the RSI works is that it calculates the speed of change of price movement in the time frame your are looking at (the difference between price of current candle and previous candles). So if a market is trading far away from where it was at the previous candle of that time frame, this will result in a more volatile oscillator. The important thing to note is that while an extended oscillator will always normalize, this does not mean the price of the market you're trading will normalize.

THE GOOD AND THE BAD - What do I mean by this? Well, there are two ways an oscillator will normalize after producing extended readings. If you are a contrarian like myself, the hope is that with a normalization of the oscillator from extended readings will come a normalization in the price of the market you are trading. So if for example the price of GBPUSD shoots through the roof on a given day and is trading 1.2750 at that time, the hope is that the normalization in the oscillator reading will coincide with a pullback in the price of GBPUSD. But as a contrarian, what you don't want to see is a normalization in the oscillator reading, while the price remains the same or higher. This is the second way an oscillator will normalize after producing extended readings. So how does this happen? Well, as highlighted above, the oscillator determines the speed of change of price movement.

THE BOTTOM LINE - So if the market shoots into overextended territory as per the oscillator but then the price of the market decides to consolidate for several hours (if hourly chart), the price relative to previous hourly candles is no longer deviating, which means a normalization in the osccilator, but the same (or relatively the same price). In this case, if not careful, a contrarian trader is vulnerable if the trader continues to hold the position. Why? Because although the price of GBPUSD was high hours back, the oscillator is no longer confirming, which means the market could easily continue higher. I think many traders make the mistake of using oscillators to gauge overextension while neglecting to continue to monitor the oscillator reading when the price is still extended in their mind but no longer extended on a technical basis. In this case, a trader needs to recognize he isn't looking at the same trade and should consider an exit. Better to take this course than to defer to a hope and hold on strategy.