One of the most popular questions I get on the blog refers to the “3/10 Oscillator.” I thought I’d take a moment and share how it’s constructed and some basics about the Oscillator.
The following chart shows the theory behind the construction of the Oscillator:
Definitionally, the 3/10 Oscillator is the Difference between a 3 and 10 Period Simple Moving Average. Technically, what I show in StockCharts.com is NOT the classic 3/10 because I’m manipulating the standard MACD which uses Exponential Moving Averages. The difference is minimal. Linda Raschke is famous for popularizing the classic indicator.
To replicate the 3/10 Oscillator, type in “3, 10, 16″ in the settings of your MACD Indicator.
The BLACK (oscillating) line in the indicator is derived from taking the difference in a 3 period SMA and a 10 period SMA, which is then plotted as a line.
The RED (‘trend’) line is derived from averaging the 3/10 Differential over 16 periods. In essence, it ’smoothes’ out the 3/10 Differential and helps show a bit of insight into ‘trend.’
The ZERO-LINE refers to the crossover points between the 3 and 10 SMAs. When the 3 SMA crosses above the 10 SMA (as occurred in late November 2008), then the Black (3/10) Line will Cross above Zero. The 3/10 will cross beneath 0 when the 3 SMA crosses beneath the 10 SMA.
The HISTOGRAM is derived from the differential between the 3/10 (Black Line) Oscillator and the Red “Trend” Line. When the 3/10 is ABOVE the Red Trend Line, then the Histogram will be above the 0-Line (vice versa for when the 3/10 is beneath the Trend Line). The true 3/10 Oscillator does not use such a histogram.
A DIVERGENCE occurs when the differential between the 3 SMA and 10 SMA is larger at one point than it is at a second point. Price makes a new low, but the difference between these averages is less, which has implications for analysis. I have highlighted an example of the “insides” of a Divergence in the 3/10. Although I’ve made price invisible, price did make a new swing low in November beneath the low of October (you can see this in the averages themselves). Look at the dotted blue (horizontal) line to see how the divergence formed.
A NEW MOMENTUM LOW (or HIGH) occurs when the differential between the 3 and 10 SMAs is larger than it has been in the recent past (as in September and October 2008). It also has short-term forecasting applications.
Here is an image of the actual 3/10 Oscillator at work from a chart (also of the DIA) I use in TradeStation:
Compare this construction to the above indicator in StockCharts.
Ultimately, most oscillators will show similar patterns, but I prefer the 3/10 Oscillator because I’ve become accustomed to its nuances and feel that one can use it as a “Three-in-one” Oscillator: Momentum Oscillator, Swing Indicator, and Trend Indicator.
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