Technical Indicators: A Primer

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.