Oscillators

Source: John J. Murphy, Technical Analysis of the Financial Markets — Oscillators Chapter

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1. Principles of Oscillator Application

Oscillators are technical indicators that measure price momentum and rate of change. They are primarily used to identify overbought and oversold conditions and to detect potential trend reversal points. While trend-following indicators (such as moving averages) reveal the direction of a trend, oscillators reveal the speed and strength of that trend. Oscillators are therefore most effective when used alongside trend indicators — relying on them alone is risky.

Fundamental Principles

• Leading indicator characteristics: Oscillators frequently provide warning signals ahead of actual price reversals. They can detect weakening momentum before price itself turns.
• Bounded range: Most oscillators move within a fixed range (typically 0–100 or −1 to +1), which makes it possible to clearly define extreme values.
• Counter-trend trading tool: Oscillators generate signals in the opposite direction when they reach extreme values. However, this very characteristic can become a trap during strong trending markets.

Three Core Applications of Oscillators

1) Extreme Values (Overbought / Oversold)

• Overbought zone: Readings above 70–80 generally signal a potential sell opportunity.
• Oversold zone: Readings below 20–30 generally signal a potential buy opportunity.
• Important caveat: In strong trends, oscillators can remain in extreme zones for extended periods. Overbought does not automatically mean an imminent decline, and oversold does not automatically mean an imminent rally. The actionable signal is not the entry into extreme territory but the exit from it — the moment the oscillator turns away from the extreme zone.

2) Centerline Crossover (50-Line Breakout)

• Upward crossover: When an oscillator crosses above the 50 line (or zero line), it signals that bullish momentum is dominant.
• Downward crossover: When it crosses below the 50 line, it signals that bearish momentum is dominant.
• Significance of the centerline: The centerline represents the equilibrium between bullish and bearish momentum. Trend direction is assessed relative to this line. In practice, frequent whipsaws can occur near the 50 line, so it is safer to wait for a decisive breakout before entering a position.

3) Divergence — The Most Important Signal

• Bullish divergence: Price makes a new low, but the oscillator forms a higher low than its previous trough. This indicates that downside momentum is weakening.
• Bearish divergence: Price makes a new high, but the oscillator forms a lower high than its previous peak. This indicates that upside momentum is weakening.
• Key significance: Divergence is the most powerful oscillator signal, suggesting a weakening of the current trend and the possibility of reversal. However, the actual reversal may take time to materialize after a divergence appears. Rather than entering immediately on divergence alone, it is safer to wait for price confirmation — such as a support break, trendline violation, or pattern completion.

The Golden Rule of Practical Application

Harmony with the Trend

This is the principle Murphy emphasizes most strongly. When using oscillators, you must first identify the dominant market trend.

• In an uptrend: Use oversold signals as buying opportunities and ignore overbought signals. In an uptrend, an overbought reading simply means "strong bullish momentum continues."
• In a downtrend: Use overbought signals as selling (or shorting) opportunities and ignore oversold signals. In a downtrend, an oversold reading simply means "strong bearish momentum continues."
• Core rationale: The trend is a more powerful force than any oscillator. Oscillators should only be used in the direction that aligns with the prevailing trend.

Effectiveness by Market Condition

Market Condition	Oscillator Usefulness	Caution
Strong trend	Low	Oscillators remain at extremes for prolonged periods; frequent false signals
Sideways / Range-bound	Very high	The most effective environment for oscillators
Trend transition	High	Divergence signals play a critical role
High-volatility spikes	Moderate	Lengthen the lookback period to filter noise

Methods to Improve Reliability

• Multi-timeframe analysis: Confirm trend direction on the weekly chart and identify entry timing on the daily chart. Win rates increase significantly when signals from higher and lower timeframes align.
• Combining multiple oscillators: When oscillators with different calculation methods — such as RSI, MACD, and Stochastic — generate signals simultaneously, reliability increases substantially.
• Integration with other technical tools: Use oscillators in conjunction with moving averages, support/resistance levels, and chart patterns. For example, an oversold signal occurring at a major support level greatly enhances the reliability of a buy signal.
• Volume confirmation: Verify whether volume increases when a signal occurs. Oscillator signals without accompanying volume carry low reliability.

Critical Mistakes in Oscillator-Based Trading

1. Standalone trading: Making trading decisions based on a single oscillator is dangerous. Always combine oscillator readings with trend analysis, support/resistance, volume, and other tools.
2. Ignoring the trend: Blindly following signals that oppose the dominant trend can lead to significant losses.
3. Over-reliance: Trusting every signal unconditionally is a mistake. Oscillators are probabilistic tools — no indicator is 100% accurate.
4. Over-optimization trap: Fine-tuning parameters to perfectly fit historical data often degrades real-world performance. Use standard settings as a baseline and make only minor adjustments to suit specific market characteristics.

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2. RSI (Relative Strength Index)

The Relative Strength Index (RSI) is a momentum oscillator introduced by J. Welles Wilder in his 1978 book New Concepts in Technical Trading Systems. It moves within a range of 0 to 100 and quantitatively assesses overbought and oversold conditions by comparing the magnitude of recent gains to recent losses. Since its introduction, it has become one of the most widely used oscillators in technical analysis.

Calculation and Settings

• Formula: RSI = 100 − [100 / (1 + RS)]
• RS (Relative Strength): Average gain over N periods ÷ Average loss over N periods
• Standard period: 14 days (Wilder's recommendation). The initial RS value is calculated using a simple average; subsequent values use an exponential smoothing method.

The core idea behind RSI is straightforward. If the average magnitude of up days over the past N days exceeds that of down days, RSI rises above 50, and vice versa. When gains are overwhelmingly dominant, RSI approaches 100; when losses are overwhelmingly dominant, RSI approaches 0.

Characteristics by Period Setting

Setting	Characteristics	Application	OB/OS Threshold Adjustment
7-day	Very sensitive, frequent signals	Short-term trading / scalping	Use 80/20 recommended
14-day	Balanced responsiveness	Standard setting / swing trading	70/30 standard
21-day	Smooth movement	Long-term perspective / position trading	70/30 or 65/35

Practical tip: Shorter periods cause the oscillator to reach extreme values more frequently, so widening the overbought/oversold thresholds to 80/20 is advisable. Conversely, longer periods reduce the frequency of extreme readings, so narrowing the thresholds to 65/35 can be appropriate.

RSI Signal Framework

Basic Signals

Zone	Interpretation	Action	Reliability
Above 70	Overbought	Consider selling	Moderate
Below 30	Oversold	Consider buying	Moderate
Cross above 50	Bullish momentum dominant	Trade in the buy direction	High
Cross below 50	Bearish momentum dominant	Trade in the sell direction	High
Above 80	Extremely overbought	Strong sell consideration	High
Below 20	Extremely oversold	Strong buy consideration	High

Important: Entry into the overbought or oversold zone is not itself a trading signal. The actionable signal is the movement out of the zone — for example, RSI declining back below 70 after having been above it.

Failure Swing — A Standalone Trading Signal

This is a signal Wilder particularly emphasized. It generates a valid trading signal based solely on the RSI pattern, even without divergence.

Top Failure Swing (Sell Signal)

1. RSI rises above 70, then declines (forming Peak A).
2. RSI drops to an intermediate low (the Fail Point).
3. RSI rallies again but fails to exceed Peak A (forming Peak B).
4. A sell signal is confirmed when RSI breaks below the Fail Point.

Bottom Failure Swing (Buy Signal)

1. RSI falls below 30, then bounces (forming Trough A).
2. RSI rises to an intermediate high (the Fail Point).
3. RSI declines again but holds above Trough A (forming Trough B).
4. A buy signal is confirmed when RSI breaks above the Fail Point.

Practical tip: Failure swings provide faster signals than divergence and are especially reliable when they occur in extreme zones. A unique advantage is that they can be identified from RSI alone, without requiring direct pattern confirmation on the price chart.

RSI Divergence — The Most Powerful Signal

Bullish Divergence (Buy Signal)

• Condition: Price forms a new low, but RSI forms a higher low than its previous trough.
• Optimal zone: Reliability is maximized when RSI is below 30.
• Confirmation: The signal is confirmed when RSI breaks above the intermediate high between the two troughs.

Bearish Divergence (Sell Signal)

• Condition: Price forms a new high, but RSI forms a lower high than its previous peak.
• Optimal zone: Reliability is maximized when RSI is above 70.
• Confirmation: The signal is confirmed when RSI breaks below the intermediate low between the two peaks.

Caution: Entering a position immediately upon the appearance of divergence is risky. In strong trends, multiple consecutive divergences can occur before an actual reversal takes place. Always wait for confirmation.

Advanced RSI Techniques

Trendline Application

Trendlines can be drawn on the RSI chart just as on the price chart — a technique Murphy specifically highlights.

• RSI trendline breakout: RSI trendlines often break before price trendlines, making them useful as early warning signals.
• RSI support and resistance: RSI frequently bounces off or is rejected at specific recurring levels.
• Channel analysis: Drawing a channel by connecting RSI highs and lows can produce powerful reversal signals when the channel is breached.

Pattern Analysis

• Triangles and wedges: Converging patterns can form on the RSI chart, and the breakout direction can foreshadow price movement.
• Head and shoulders: When a head-and-shoulders pattern appears on RSI in conjunction with divergence, it constitutes a very strong reversal signal.
• Double tops / double bottoms: Variants of the failure swing pattern, frequently observed in RSI extreme zones.

RSI Range Shift

During strong trend transitions, the oscillating range of RSI itself shifts — a phenomenon worth monitoring.

• Bullish shift: RSI tends to oscillate primarily within the 40–80 range. The 40 level acts as support and the 80 level as resistance.
• Bearish shift: RSI tends to oscillate primarily within the 20–60 range. The 60 level acts as resistance and the 20 level as support.
• Application: Observing the operating range of RSI helps determine whether the market is in a bullish or bearish regime.

Practical RSI Considerations

Dangerous Situations

1. Strong trending markets: RSI can remain above 70 (in uptrends) or below 30 (in downtrends) for extended periods, rendering overbought/oversold signals ineffective.
2. Parabolic rallies and crashes: RSI may reach extreme values while price continues to move significantly further. Counter-trend entries in these conditions can lead to substantial losses.
3. Low-volume environments: RSI signal reliability drops significantly in illiquid markets.

Combinations That Improve Reliability

• RSI + Volume: RSI signals accompanied by rising volume carry higher reliability.
• RSI + Support/Resistance: When an RSI signal coincides with a key price level, it provides strong trade justification.
• RSI + MACD: Use RSI to identify overbought/oversold conditions and MACD crossovers to confirm entry timing.
• RSI + Bollinger Bands: A simultaneous touch of the lower Bollinger Band and an RSI oversold reading enhances buy signal reliability.
• Multi-timeframe RSI: Enter only when the weekly RSI direction aligns with the daily RSI signal.

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3. MACD (Moving Average Convergence Divergence)

The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator developed by Gerald Appel in the late 1970s. By measuring the difference between two moving averages, it simultaneously captures trend direction, strength, and reversal points — earning it a reputation as a "versatile indicator." Its utility was further enhanced when Thomas Aspray later added the histogram component.

Components and Calculation

Core Components

• MACD Line: 12-day EMA − 26-day EMA (the difference between a short-term and a long-term moving average)
• Signal Line: 9-day EMA of the MACD Line (a smoothed version of the MACD)
• Histogram: MACD Line − Signal Line (the gap between the two lines, displayed as a bar chart)

A positive MACD Line means the short-term moving average is above the long-term moving average, indicating that recent bullish momentum is dominant. The histogram visualizes the gap between the MACD Line and the Signal Line, making it the fastest component for detecting momentum changes.

Meaning of Each Component

Component	State	Interpretation
MACD > 0	Short-term EMA > Long-term EMA	Bullish momentum dominant
MACD < 0	Short-term EMA < Long-term EMA	Bearish momentum dominant
Histogram > 0	MACD > Signal	Bullish momentum accelerating
Histogram < 0	MACD < Signal	Bearish momentum accelerating
Histogram increasing	Gap between lines widening	Current trend strengthening
Histogram decreasing	Gap between lines narrowing	Current trend weakening

MACD Signal Framework

Primary Signal: MACD and Signal Line Crossover

The most fundamental and widely used signal.

• Bullish crossover (Golden Cross): The MACD Line crosses above the Signal Line — a buy signal.
• Bearish crossover (Death Cross): The MACD Line crosses below the Signal Line — a sell signal.
• Enhanced reliability: A bullish crossover occurring below the zero line, or a bearish crossover occurring above the zero line, tends to be more reliable.

Secondary Signal: Zero Line Crossover (Medium-Term Trend Change)

• Upward crossover: When the MACD Line rises above the zero line, a medium-term uptrend is confirmed. This is equivalent to the 12-day EMA crossing above the 26-day EMA.
• Downward crossover: When the MACD Line falls below the zero line, a medium-term downtrend is confirmed.

Tertiary Signal: Histogram (The Earliest Warning)

The histogram is the fastest tool in MACD analysis for detecting momentum shifts.

• Histogram turns positive: Signals a shift to bullish momentum (an imminent MACD bullish crossover).
• Histogram turns negative: Signals a shift to bearish momentum (an imminent MACD bearish crossover).
• Histogram converging toward zero: Indicates that a crossover is approaching.
• Key point: The most valuable early warning comes from a change in histogram direction — when positive bars begin shrinking, or when negative bars begin shrinking.

MACD Divergence Analysis

Bullish Divergence

• Condition: Price forms a new low, but the MACD (or histogram) forms a higher low than the previous trough.
• Confirmation: Enter a long position when the MACD Line crosses above the Signal Line.
• Target setting: Use the prior high or the price at the start of the divergence as the initial target.

Bearish Divergence

• Condition: Price forms a new high, but the MACD (or histogram) forms a lower high than the previous peak.
• Confirmation: Enter a short position (or sell) when the MACD Line crosses below the Signal Line.
• Target setting: Use the prior low or the price at the start of the divergence as the initial target.

Practical tip: MACD divergence can be detected more quickly by observing the histogram. If the histogram's peak is lower than the previous peak while price makes a new high, this is an early warning of bearish divergence.

Advanced MACD Strategies

Multi-Timeframe Analysis

One of the most powerful methods for deploying MACD effectively.

1. Weekly MACD — Confirm medium- to long-term direction

   • Weekly bullish crossover → Major uptrend phase
   • Weekly bearish crossover → Major downtrend phase

2. Daily MACD — Determine entry timing

   • Use only daily signals that align with the weekly direction.
   • Weekly bullish: Buy only on daily bullish crossovers.
   • Weekly bearish: Sell only on daily bearish crossovers.

3. 4-hour / 1-hour MACD — Fine-tune timing

   • Particularly useful in markets that trade 24/7, such as cryptocurrency.

Effect of Changing MACD Parameters

Settings (Fast, Slow, Signal)	Characteristics	Application
(12, 26, 9)	Standard setting, balanced response	General purpose
(5, 35, 5)	Fast response, frequent signals	Short-term trading
(8, 17, 9)	Medium speed	Swing trading
(19, 39, 9)	Slow response, stable	Long-term investing

Cryptocurrency market note: Cryptocurrency markets are significantly more volatile than traditional markets, so the standard (12, 26, 9) setting may produce excessive noise. During periods of extreme volatility, consider adjusting to longer-period settings or focusing analysis primarily on the histogram.

Detailed Histogram Analysis

• Histogram increasing: The current trend is accelerating.
• Histogram decreasing: The current trend is decelerating. This is the first warning of a potential reversal.
• Histogram double top / double bottom: Double tops or double bottoms on the histogram frequently signal trend reversals ahead of similar patterns on the price chart.

MACD Practical Trading Insights

MACD in Bull Markets

• Buy timing: After a corrective pullback, prepare to buy when the histogram begins shrinking from negative territory (converging toward zero).
• Holding strategy: Maintain the position as long as the weekly MACD Line remains above the Signal Line.
• Core principle: Do not sell simply because MACD is at a high level. In bull markets, MACD can sustain elevated readings for extended periods.

MACD in Bear Markets

• Sell timing: After a relief rally, prepare to sell (or short) when the histogram begins shrinking from positive territory.
• Short-selling strategy: Only short when the weekly MACD Line is below the Signal Line.
• Core principle: Do not buy simply because MACD is at a low level.

MACD Limitations and Countermeasures

1. Frequent whipsaws in sideways markets

   • The MACD Line and Signal Line repeatedly cross within a narrow range, generating false signals.
   • Countermeasure: Confirm with volume and refer to the higher-timeframe direction. Ignore crossovers where the histogram bars are extremely small.

2. Lagging signals

   • MACD is inherently a lagging indicator because it is based on moving averages. Confirmation of a trend change takes time.
   • Countermeasure: Use the histogram's directional change as an early signal.

3. Traps in strong trends

   • In extremely strong trends, a bearish MACD crossover may prove to be nothing more than a minor pullback.
   • Countermeasure: Use the zero line crossover as the key criterion. A bearish crossover above the zero line may indicate a mere "correction," whereas a break below the zero line signals an actual trend change.

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4. Stochastic Oscillator

The Stochastic Oscillator was developed by George Lane in the 1950s. It expresses the relative position of the current closing price within a given period's price range as a percentage from 0 to 100. The core premise is that in an uptrend, closing prices tend to cluster near the top of the range, while in a downtrend, they tend to cluster near the bottom. Because the position of the close shifts before the trend actually reverses, the Stochastic can capture early reversal signals.

Calculation Structure

Basic Formulas

• %K: (Current Close − N-period Low) / (N-period High − N-period Low) × 100
• %D: 3-period simple moving average of %K (acts as the signal line)
• Slow %K: 3-period simple moving average of %K (identical to Fast %D)
• Slow %D: 3-period simple moving average of Slow %K

A %K reading of 80 means the current close is at the 80th percentile of the N-period price range. A reading of 20 means it is at the 20th percentile.

Fast Stochastic vs. Slow Stochastic

Type	%K	%D	Characteristics
Fast Stochastic	Raw %K	3-period SMA of %K	Very sensitive; noisy and difficult to use in practice
Slow Stochastic	Fast %D (= 3-period SMA of %K)	3-period SMA of Slow %K	Smoother movement; most widely used in practice

Practical recommendation: Most traders and charting platforms use the Slow Stochastic by default. The Fast Stochastic generates too much noise, resulting in excessive false signals in live trading.

Stochastic Signal Analysis

Core Trading Rules

Signal Type	Condition	Reliability	Notes
Strong buy	%K crosses above %D + below 20 zone	High	Bullish reversal from oversold
Strong sell	%K crosses below %D + above 80 zone	High	Bearish reversal from overbought
Weak buy	%K crosses above %D + in 20–80 zone	Low	Neutral zone crossover; trend confirmation needed
Weak sell	%K crosses below %D + in 20–80 zone	Low	Low reliability; confirm with other indicators

The critical factor is the location of the crossover. Only crossovers occurring in extreme zones (above 80 or below 20) carry high reliability. Crossovers in the neutral zone have a high probability of being false signals and should only be acted upon after confirming the trend.

Zone-by-Zone Interpretation

• 80–100 (Overbought zone): The close is positioned near the top of the price range. Selling pressure may build, but in a strong uptrend, it is normal for the Stochastic to remain in this zone for an extended period.
• 20–80 (Neutral zone): Directional bias is difficult to determine. Signals in this zone should not be used in isolation.
• 0–20 (Oversold zone): The close is positioned near the bottom of the price range. This may represent a buying opportunity, but in a strong downtrend, the Stochastic can remain in this zone for an extended period.

Advanced Stochastic Signals

Divergence (The Most Important Signal)

Stochastic divergence was the signal Lane considered most important.

• Bullish divergence: Price makes a new low, but %D forms a higher low than its previous trough.

  • Extremely powerful as a buy signal when it occurs below 20.
  • The entry point is the moment %K crosses above %D.

• Bearish divergence: Price makes a new high, but %D forms a lower high than its previous peak.

  • Extremely powerful as a sell signal when it occurs above 80.
  • The entry point is the moment %K crosses below %D.

Hinge Pattern

A hinge occurs when the slope of %K or %D changes sharply and flattens out, typically appearing just before a directional change.

• Bullish hinge: Below 20, both %K and %D move sideways, accumulating energy before breaking upward.
• Bearish hinge: Above 80, both %K and %D move sideways, exhausting energy before breaking downward.
• Significance: A hinge provides a stronger directional signal than a simple crossover and can capture the early stages of a trend reversal.

%K and %D Crossover — Detailed Observations

• The steeper the angle at which %K crosses %D, the stronger the momentum.
• A nearly parallel (shallow-angle) crossover is likely a weak signal.
• When %D has already reversed direction before %K crosses it, the signal carries higher reliability.

Stochastic Settings and Optimization

Characteristics by Period Setting

Period	Characteristics	Application	Pros	Cons
5-day	Very sensitive	Short-term scalping	Fast response	Frequent false signals
14-day	Standard	Swing trading	Balanced signals	—
21-day	Less sensitive	Long-term investing / position trading	Stable signals	Late entries

Smoothing Settings

• %D period: 3 (standard) is the most common; extending to 5 produces a smoother curve.
• Slow Stochastic: The additional smoothing effectively eliminates noise.
• Practical recommendation: Slow Stochastic (14, 3, 3) is the most versatile setting. Consider (5, 3, 3) for short-term trading and (21, 5, 5) for long-term analysis.

Stochastic Practical Trading Strategies

Application by Trend

1. Uptrend

   • Use only bullish crossover signals from the oversold zone (below 20).
   • A %K crossover above %D near the 50 line can also serve as a supplementary signal.
   • Ignore overbought signals (above 80). In an uptrend, a Stochastic reading persistently above 80 is evidence of continued bullish strength.

2. Downtrend

   • Use only bearish crossover signals from the overbought zone (above 80).
   • A %K crossover below %D near the 50 line can also serve as a supplementary signal.
   • Ignore oversold signals (below 20). In a downtrend, a Stochastic reading persistently below 20 is evidence of continued bearish strength.

3. Sideways / Range-bound market

   • All overbought/oversold crossover signals can be utilized.
   • A range-trading strategy of selling at 80 and buying at 20 is most effective.
   • This is the environment where the Stochastic truly excels.

Combining with Other Indicators

• Stochastic + RSI: When both indicators simultaneously show overbought or oversold conditions, reliability increases significantly. Since their calculation methods differ, concurrent extreme readings constitute a powerful signal.
• Stochastic + MACD: Use the Stochastic for short-term timing and MACD for medium-term directional confirmation. When MACD confirms an uptrend and the Stochastic simultaneously generates a buy signal from oversold territory, the result is a high-probability entry point.
• Stochastic + Moving Averages: When price is above the moving average (confirming an uptrend), use only the Stochastic's oversold buy signals.
• Stochastic + Candlestick Patterns: When reversal candlestick patterns (hammer, engulfing, etc.) appear simultaneously with Stochastic extreme readings, entry reliability is maximized.

Stochastic Cautions and Pitfalls

Common Mistakes

1. Over-trusting neutral zone signals: Excessive reliance on crossovers in the 20–80 zone leads to frequent stop-outs.
2. Standalone use: Trading solely on Stochastic signals without other indicators or analysis significantly reduces win rates.
3. Ignoring the trend: Following counter-trend signals in a strong trend can result in substantial losses. The Stochastic should only be used in the direction that aligns with the prevailing trend.
4. Using Fast Stochastic: The noisy Fast version causes traders to be repeatedly caught by false signals.

Countermeasures

• Volume confirmation: When volume increases alongside a signal, the probability of a genuine reversal is higher.
• Support/resistance alignment: Prioritize Stochastic signals that occur at key price levels.
• Higher-timeframe confirmation: Validate daily signals against the weekly chart. Take only daily signals that align with the weekly Stochastic direction.
• Combine with pattern analysis: Make decisions in conjunction with support/resistance breaks, trendline violations, and chart pattern completions on the price chart.

Adapting to Market Conditions

Market Environment	Recommended Setting	Approach
High volatility	21-day or longer period	Increase smoothing; widen extreme thresholds
Low volatility	5–9-day short period	Increase sensitivity to capture small moves
Gap events	No setting change needed	Be wary of sudden Stochastic jumps; account for reduced signal reliability
Low liquidity	Long-period settings recommended	Strengthen noise filtering; cross-confirm with other indicators

Cryptocurrency market note: Since crypto markets trade 24/7, price gaps are rare. However, sharp price swings caused by major news or regulatory events are frequent. During such volatile episodes, the Stochastic can become pinned at extreme values or fluctuate wildly. It is safer to wait for signals that emerge after volatility has stabilized.