The Chaikin Oscillator measures the momentum of the Accumulation/Distribution Line. More specifically, it measures the different between the 3-day and 10-day moving averages of the Accumulation/Distribution Line, and is designed to anticipate directional changes by measuring the momentum behind the movements. A momentum change is the first step to a trend change.
It is important to note that the Chaikin Oscillator is an indicator of an indicator, making it three steps removed from the underlying price of the security. First, price and volume are reshaped into the Accumulation/Distribution Line. Second, moving averages (3- and 10-day) are applied to that Line. Third, the difference between the moving averages is used to form the Chaikin Oscillator.
The indicator is designed to measure the momentum behind buying and selling pressure (Accumulation Distribution Line). A move into positive territory indicates that the Accumulation Distribution Line is rising and buying pressure prevails. A move into negative territory indicates that the Accumulation Distribution Line is falling and selling pressure prevails.
Technicians typically use the Chaikin Oscillator to visualize how the price action has reacted to similar levels of buying/selling pressure in the past. If the Chaikin Oscillator is very high, it may be a signal that the security is overbought and more likely to sell-off. Conversely, a low indication may historically precede significant rallies.
As an example, I added lines of potential support (blue) and resistance (red) to the SPY daily chart below. Four of the five previous instances of the Chaikin Oscillator reaching – or dropping under – the blue line, led directly into substantial rallies in the SPY. One instance in mid-May was followed by a continuation in selling pressure. On the flip side, the red line of resistance was far weaker in indicating a potential change in trend. Nearly half of the instances failed. It’s important to analyze the success of the indicator for each individual security before deriving at a conclusion. In this specific case, we’re much more comfortable calling a bottom than we are calling a top in the SPY based on the Chaikin Oscillator.
A bullish divergence forms when price moves to new lows and the Chaikin Oscillator forms a higher low. This higher low shows less selling pressure. It is important to wait for some sort of confirmation, such as an upturn in the indicator or a cross into positive territory. A move into positive territory shows upside momentum in the Accumulation Distribution Line.
A bearish divergence forms when price moves to a new high and the Chaikin Oscillator fails to confirm this higher highs. This failure reflects less buying pressure that can sometimes foreshadow a bearish reversal.
The green lines in the chart above show the Chaikin Oscillator forming divergences (both bullish and bearish).