There are many ways to build a momentum oscillator, but the actual interpretation varies little from one technique to another. Most oscillators even look similar as they are plotted along the bottom of the price chart resembling a flat horizontal band. The band remains basically flat while prices may be trading up, down, or sideways. However, the peaks and valleys in the oscillator will coincide with those on the price chart. Some oscillators have a midpoint value which divides the range into an upper and lower half. Certain formulas call this midpoint a zero line. Some also have upper and lower boundaries ranging from 0 to 100.

When the oscillator reaches an extreme value in the upper or lower end of the band, it usually means, as a general rule, the current price has moved too far too fast and is headed for either a correction or consolidation of some type. Another general rule is that the stock trader should be buying when the oscillator is in the lower end of the band and selling in the upper end. The crossing of the midpoint line is most often used to generate buy and sell signals.

There are three situations where oscillators are most useful. You will find these three situations are common to most type of oscillators:

• The oscillator is most useful when it reaches an extreme value near the upper or lower end of its boundaries. The market is labeled overbought when the oscillator is near the upper extreme and oversold when it's nearer the lower extreme. Both these conditions warn the price trend is overextended and vulnerable.
• It is usually considered an important warning when there is a divergence between the oscillator and the price action in an extreme position.
• The crossing of the midpoint or zero line can give important trading signals in the direction of the trend.

Andy Swan is co-founder and head trader for DaytradeTeam.com.  To get all of Andy's day trading, swing trading, and options trading alerts in real time, subscribe to a one-week, all-inclusive trial membership to DaytradeTeam by clicking here.