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Using the A/D Oscillator

There are several potential applications of the A/D oscillator for position and day trading. They range from the artistic and interpretive to the mechanical and objective. Since this book is not about art but about the quasi-science of technical analysis, I will refrain from a discussion of the artistic application of the A/D oscillator. While my application may not be as scientific as one would like, my efforts are in the correct direction. One method I have worked with extensively is to buy and sell based on A/D oscillator crosses above and below the zero line. The construction of the oscillator suggests that when the A/D value is above zero, the market is under accumulation, or the bulls are in control.

Conversely, when the A/D value is below zero the bears are in control of the market. Theoretically, when the A/D crosses from plus to minus, a market crosses from bullish to bearish and vice versa. Figures 13-4 through 13-6 support the argument, each showing the A/D oscillator and market trend. Note how the A/D oscillator has the uncanny ability to remain negative for a lengthy period of time as prices continue to decline or positive for a lengthy period of time as prices continue to rally. That's the good news about the A/D oscillator. The bad news is that these are ideal situations that do not occur as frequently as we would like. All too often markets move higher and higher while the A/D is in negative ground and vice versa. Such situations not only confuse the trader into thinking that the theory is incorrect, but they are also costly, since they produce losses. Yet another limitation of the A/D and, indeed, of all oscillators, is that they can frequently move back and forth above and below the zero line numerous times before a sustained trend emerges. Traders who buy and sell on such frequent crosses above and below the zero line will suffer numerous repeated losses, not to mention the cost of commissions and slippage.

As an example, of this limitation, consider Figure 13-7. This figure shows March 1998 coffee futures with an A/D oscillator that remains negative until the top of the market in December 1997. After the oscillator crosses into positive ground, the market tops and declines sharply. How can such a severe limitation be overcome? The approach I suggest is to use a derivative of the A/D line that will generate signals when the A/D line crosses above and below its first derivative. In this case the derivative will be a moving average of the A/D line as explained in the next section.