Technical Classroom: How to use Ultimate Oscillator indicator for successful trading

It combines short-term, intermediate-term, and long-term price action into one oscillator and attempts to give overbought and oversold readings, potential buy and sell signals, and confirmations of price action as well as divergences that might warn of future price reversals.

It is used in various capacities including overbought/oversold levels, momentum confirmations and providing trade signals.

The indicator is useful for technical analysis because it takes more standard momentum oscillators, and adjusts the calculation in order to strengthen a common weakness among them.

However, it really becomes most effective when confirming signals or conditions identified by additional technical analysis.

Construction of Ultimate Oscillator Indicator

Understanding underlying formula used for construction of Ultimate Oscillator helps traders to take prudent decision, while trading complex scenarios.

The indicators fluctuate between 0 and -100. Calculating the indicator is no longer required, as charting platforms and trading software do it for us.

Although knowing how the indicator is calculated will help you better understand the indicator and its strengths and weaknesses. Ultimate Oscillator indicator is calculated using the following formula:

The Ultimate Oscillator is available on most trading platforms, such as Tradingview and MetaTrader. The indicator is also available on many free online charting sites, such as Investing.com, StockCharts.com and Yahoo! Finance.

Working of Ultimate Oscillator Indicator

- Buying Pressure and its relationship to the True Range forms the base for the Ultimate Oscillator.
- The best way to measure Buying Pressure is simply subtracting the Close from the Low or the Prior Close, whichever of the two is the lowest. This will reflect the true magnitude of the advance, and hence, buying pressure.
- The Ultimate Oscillator rises when Buying Pressure is strong and falls when Buying Pressure is weak.
- The Ultimate Oscillator measures momentum for three distinct time frames. Notice that the second time frame is double that of the first and the third time frame is double that of the second.

- Even though the shortest time frame carries the most weight, the longest time frame is not ignored, which should reduce the number of false divergences.
- The indicator uses three time frames in its calculation: 7, 14, and 28 periods.
- The shorter time frame has the most weight in the calculation, while the longer time frame has the least weight.
- Buy signals occur when there is bullish divergence, the divergence low is below 30 on the indicator, and the oscillator then rises above the divergence high.
- A sell signal occurs when there is bearish divergence, the divergence high is above 70, and the oscillator then falls below the divergence low.
- Like all technical indicators, it is important to use the UO in conjunction with other technical analysis tools.

Trading Technique:

The problem with many momentum oscillators is that after a rapid advance or decline in price, they can form false divergence trading signals.

For example, after a rapid rise in price, a bearish divergence signal may present itself, however price continues to rise. The UO attempts to correct this by using multiple time frames in its calculation as opposed to just one time frame which is what is used in most other momentum oscillators.

A straightforward simplification of the indicator is that it is a way to measure buying pressure. Williams identified a buy signal a based on a bullish divergence and a sell signal based on a bearish divergence. Historical analysis and research can assist in finding appropriate indicator parameters.

The centerline, -50, is an important level to watch. UO moves between 0 and -100, which makes 50 the midpoint. Usage of Trend lines & Moving Average is the most effective way while trading with UO Indicator. Moving Average and UO together are used to develop trading strategy. Key points about it are discussed below:

Buy Signal:

Entry
- Buy Signal Oversold Area: The Ultimate Oscillator must have reached oversold status (below 30), before a buy signal can be given.
- Bullish Divergence: When price makes a new low, but the Ultimate Oscillator makes a higher low.
- Ultimate Oscillator Breakout: When the Ultimate Oscillator closes above the highest high during the bullish divergence.

Exit
- One can use multiple ways to book profit & exit, like UO near 50 or UO near oversold levels (30).

Sell Signal:

Entry

- Sell Signal Overbought Area: The Ultimate Oscillator must have reached overbought status (above 70), before a sell signal can be given.
- Bearish Divergence: When price makes a new high, but the Ultimate Oscillator makes a lower high.
- Ultimate Oscillator Breakout: When the Ultimate Oscillator closes below the lowest low during the bearish divergence.

-

Exit

- One can use multiple ways to book profit & exit, like UO near 50 or UO near overbought levels (80).

Conclusion

- Ultimate Oscillator is an overbought and oversold technical indicator that may offer potential buy and sell signals.
- The basic buy signal is based on a bullish divergence and the basic sell signal is based on a bearish divergence.
- By including multiple time frames and weighting them accordingly the UO aims to cut down false signals.
- The Ultimate Oscillator is a momentum oscillator that incorporates three different timeframes. Traditional signals are derived from bullish and bearish divergence, but chartists can also look at actual levels for a trading bias.

(The Author is Head - Technical & Derivative Research at Narnolia Financial Advisors.)

Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.