What it is:
How it works (Example):
The McClellan Oscillator 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 Oscillator is complex. Essentially, the oscillator takes two exponentially smoothed moving averages (EMA) of advancers less decliners (A-D). 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 yields a specific McClellan Oscillator number.
Traditionally, a reading of +100 on the Oscillator is interpreted to mean 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. By contrast, the market is oversold when the oscillator reaches -100, 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 activity. However, McClellan Oscillators can be calculated on any exchange.
For example, the Oscillator can also be useful in diagnosing when the Nasdaq has reached an extreme. The Nasdaq overbought/oversold readings are +40 and -40.
On the NYSE, traders typically pay careful attention to readings of +100 and -100. However, traders often 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.
Why it Matters:
When a market becomes overextended, it is 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. By using the McClellan Oscillator, traders often have the ability to identify the beginning of a short-term trend reversal, potentially maximizing profits.