THE MCCLELLAN OSCILLATOR HELPS CALL MARKET TURNS

In my Swing Trader newsletter I frequently reference the McClellan Oscillator as a way of diagnosing whether the overall market is overbought or oversold. When combined with the Arms Index, which I discussed in a separate educational lesson, the two measures pack a powerful one-two punch at being able to identify deeply overextended markets. When a market is overextended, it is often like a spring that is held down with strong pressure. When released, the spring snaps back with great force. An overextended market can, at least in the short-term, rapidly reverse. The ability to identify short-term reversals can help the swing trader enter the market close to the beginning of a Minor trend to maximize profits.

The McClellan Oscillator was first designed by Sherman and Marian McClellan in 1969. As a substitute for this indicator, traders can also stochastics or RSI when applied to an index such as the S&P 500 or New York Stock Exchange Index (NYSE), as these are both overbought/oversold measures. The McClellan Oscillator, however, adds a different perspective because it works with market breadth. Breadth is defined as the balance between advancing issues (all stocks up at least a penny on the day) and declining issues (all stocks down by at least a penny). In a strong market, advancers will usually overwhelm decliners by a significant margin. The opposite is true when a market turns weak.

The mathematics behind the McClellan Oscillator are complex. Essentially, the oscillator takes two exponentially smoothed moving averages (EMA) of advancers less decliners. The first is a 19-period EMA, which is meant to represent the short- to intermediate-term period. The second is a 39-period moving average, which describes a more intermediate trend.

The formula for the McClellan Oscillator is:

(19-Day EMA of A-D) - (39-Day EMA of A-D)

This calculation results in a specific McClellan Oscillator number. On Thursday, March 25th, for example, the McClellan Oscillator on the New York Stock Exchange closed at �78, up from Wednesday's deeply oversold reading of �168. 

The traditional way to interpret the Oscillator number is as follows. A reading of +100 on the Oscillator means the market has become overbought. While a market can stay overbought for an extended period of time, traders should be alert to any signals of selling pressure. When the oscillator reaches �100 the opposite is true and traders should be alert to a rally. 

The middle point of the oscillator is the zero line. A cross of the zero line after a reading of + or �100 provides confirmation that the previous trend has reversed. 

Typically, the McClellan Oscillator is juxtaposed against the New York Stock Exchange Index (NYSE), as that is considered the broadest measure of trading on that exchange. McClellan Oscillators can be calculated on any exchange, and the Oscillator for the Nasdaq also is vital for diagnosing when that exchange is at an extreme. The Nasdaq overbought/oversold readings are +40 and �40.

On the NYSE, I pay careful attention to readings of + and � 100. However, I give even more emphasis to the Oscillator's own recent "signature" in determining "true" extremes. The signature is a horizontal support or resistance area that aligns with market turns.

Below you will find a chart of the McClellan Oscillator aligned with the NYSE Composite Index. In the past two months, the McClellan Oscillator has bottomed near �200 on four separate occasions. For me, that is the "true" level to now be watching for important turns.

That extreme �200 reading is indicative of the very heavy selling pressure we have witnessed throughout the past two months. (This selling pressure has ravaged the McClellan Summation Index, taking it from over 5500 to a current reading near 2000. I will comment on the significance of that next week.)

From now on, when I cite a specific McClellan Oscillator reading, you will ideally be able to put that number into a meaningful context. I will be watching the Oscillator's behavior keenly over the next few days. The question I have is whether this rally will be strong enough to bring it back over the zero line. Will the Oscillator merely approach zero, as it did on the previous rally attempt, and then peter out? The answer to that question will be a very important factor in determining whether the correct swing trading strategy will be from the long or the short side. I'll be certain to keep you posted.

Good trading!

Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader