Helene Meisler from Thestreet.com on the A-D 10DMA
Overbought/Oversold Oscillator
There are many ways to calculate an oscillator. The one I use is a simple 10-day moving average of the net differential of advancing issues minus declining issues on the New York Stock Exchange.
Overbought and oversold have to do with momentum and not necessarily price. This is an important point: Just because a market has slid in a big way does not necessarily mean it is oversold -- and vice versa. Since this is a momentum-related measure, one should be more concerned with the magnitude rather than the actual level of the move.
For example, a truly weak market can get oversold and stay oversold by simply gaining downside momentum.
Because it's a simple 10-day moving average, we concentrate on the string of numbers we are "dropping." Take the following case using this simple 10-day moving average: Let's say the market is currently in oversold territory, and 10 days ago, the market was down and the A/D was poised at a reading of minus 500.
That would mean that today, 10 days later, we would be "dropping" this reading of minus 500. If the market is down today and the A/D gives us a reading of minus 300, then, in effect, we will be adding the difference between that reading 10 days ago and today, or plus 200.
That shows a lessening of downside momentum. You see, it's down -- but not as bad as it was 10 days ago. We can now say the market has reached a short-term trough in its oversold reading.
However, if instead, today the A/D had a reading of minus 700, then there would be a loss of another 200 on the oscillator. That would mean there is still a lot of downside momentum, and therefore, while the market might be oversold, it has not yet peaked. Lacking this crucial signal, we would have to conclude that the market is not yet poised for a decent bounce.
The Oscillator and Divergences
Because we are concerned with the magnitude of the oscillator, we use it to judge the strength of the move. A reading of less overbought (i.e., a lower peak) accompanied by a higher high in the Dow Jones Industrial Average would be considered a negative divergence, as the momentum on this move was less than the previous move.
Therefore, when we get a peak reading in the oscillator in conjunction with a high in the Dow or the S&P 500, we conclude the market is overbought. After the market backs off some and begins to rally again, we will measure the magnitude of that rally by watching to see if the oscillator can better its previous reading.
If it betters its previous overbought reading, the momentum is intact. If it turns down shy of the previous peak, we conclude momentum is waning and label that a negative divergence. It says to be cautious in here.
The best way to use this indicator, though, is for positive and negative divergences. If the market is rallying and the Dow peaks around the same time it becomes overbought, then we must conclude that it is simply overbought and must look for some weakness to begin buying again.
However, after the oscillator swings back down to oversold territory and rallies once again toward overbought, we can once again look for the peak of this rally. If the Dow subsequently makes a new high and the oscillator does not, that is a negative divergence. It tells us the momentum on this rally is not as strong as the previous rally. It says to be cautious in here.
If, on the other hand, the Dow fails to make a new high but the oscillator surpasses its previous overbought level, we know that there's still underlying strength and that stocks should be bought; there is still momentum left in the market.
The same holds true for declining markets, where the tendency is for a market to become oversold.
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