Like many professions, trading involves a lot of jargon that is difficult to follow by someone new to the industry. This article will outline what it means for a currency pair to be overbought or oversold, and what trading opportunities arise from these situations.
Overbought vs Oversold talking points:
Overbought means an extended price move to the upside; oversold to the downside
When price reaches these extreme levels, a reversal is possible
The Relative Strength Index (RSI) can be used to confirm a reversal
OVERBOUGHT VS OVERSOLD
These two terms actually describe themselves pretty well. Overbought defines a period of time where there has been a significant and consistent upward move in price over a period of time without much pullback. This is clearly defined by a chart showing price movement from the “lower-left to upper-right” like the chart shown below.
The term oversold illustrates a period where there has been a significant and consistent downward move in price over a specified period of time without much pullback. Essentially, a move from the “upper-left to the lower-right” – see chart below.
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LEARN FOREX: AUD/JPY WEEKLY CHART – OVERSOLD
Since price cannot move in one direction forever, price will turn around at some point. Currency pairs that are overbought or oversold sometimes have a greater chance of reversing direction however, could remain overbought or oversold for a very long time. Therefore, traders need to use an oscillator to help determine when a reversal could occur.
OVERBOUGHT OVERSOLD INDICATOR READINGS WITH RSI
There is a quick tool traders can use to gauge overbought and oversold levels, the Relative Strength Index (RSI). The premise is simple, when RSI moves above 70, it is overbought and could lead to a downward move. When RSI moves below 30, it is oversold and could lead to an upward move.
RSI OVERBOUGHT AND OVERSOLD LEVELS:
Traders need to be patient before entering trades using the RSI as on occasion the RSI can stay overbought or oversold for a prolonged period as seen on the chart below. A common error made by traders is attempting to pick a top or bottom of a strong move that continues to move further into overbought or oversold territory. The key is to delay until the RSI crosses back under the 70 or over the 30 as an instrument to enter.
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RSI PROLONGED OVERBOUGHT AND OVERSOLD SIGNALS
The image above shows the RSI clearly breaking above the 70 level resulting in an overbought reading, but a seasoned trader will not look to immediately sell because there is uncertainty as to how far price could continue to rally. Traders ideally will wait until the RSI falls back below 70 and then place a short trade. This gives a better entry and a higher probability trade. When the RSI falls below 30, same rules apply.
FREQUENTLY ASKED QUESTIONS (FAQs)
How reliable are overbought and oversold signals?
Overbought and oversold signals as a solitary signal is not entirely reliable. Think of building a house; a builder is reliant on a hammer but as an isolated tool, the hammer is worthless when building an entire house. Other tools will be needed in conjunction with the hammer for construction – saw, drill etc. The same concept relates to overbought/oversold signals which requires complimentary tools to strengthen the signal, and eventually allow traders to make sound trade decisions. For example, trend identification, risk management and sentiment are useful tools that help compliment overbought and oversold signals.
What can traders do to strengthen/support overbought and oversold signals?
There are several common tools that can be used to compliment overbought and oversold signals. Below is a list of tools that can enhance your trading decisions:
Identify the trend – Filtering for the trend can aid traders in selecting entry points using overbought and overbought signals. For example, in an uptrend traders will filter for oversold signals as ‘long entry’ points which correlate to direction of the trend. The opposite will apply to a downtrend.
Risk management – Using proper risk-reward ratios which relate to stop and limit levels should be adhered to.
Sentiment- Utilize client sentiment data to further verify overbought and oversold signals.
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BECOME A BETTER TRADER WITH THESE TRADING INSIGHTS
Another useful indicator when it comes to assessing momentum or trend strength is the stochastic oscillator
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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
You buy a stock when it has been oversold because it is undervalued
undervalued
An undervalued stock is believed to be priced too low based on current indicators, such as those used in a valuation model. Should a particular company's stock be valued well below the industry average, it may be considered undervalued.
and the stock will rally on a price bounce. When a stock is overbought, you sell it straight away because a pullback will occur. The stock is overvalued.
In simple terms, when the market is overbought, it means that the asset has been overbought and may be poised to fall. Conversely, when the market is oversold, it means that assets have been sold in excess and may be poised to rise.
Are oversold assets good to buy? Yes, these stocks offer investors profitable opportunities. Such stocks are undervalued; after the price bounce, they can be sold at a profit.
Overbought assets are generally considered suitable for sale. The definition of oversold depends, though, on who you ask. Fundamental traders believe that an asset is oversold when its price is lower than its fair or intrinsic value. Therefore, they trade lower than their perceived worth.
An overbought stock is one that is overvalued, which means the outlook is bearish as there will be a pullback on the stock soon, meaning its price will fall as investors start selling.
Overbought stocks are those that have seen a rapid increase in price and may be due for a correction. On the other hand, overvalued stocks are those that are trading at a price that is higher than their intrinsic value.
The Relative Strength Index (RSI) is like a fitness tracker for the underlying time series. It measures how overbought or oversold an asset is, which is kinda like saying how tired or energized it is.
Negative and falling values may be a sign of strong downside momentum. Use the signal MA line to identify whether the indicator values are increasing or decreasing. Stochastic MACD's overbought and oversold levels are set to +10 and -10, respectively.
Even if a stock or other asset is a good buy, it can remain oversold for a long time before the price starts to move higher. This is why many traders watch for oversold readings but then wait for the price to start moving up before buying based on the oversold signal.
Overbought is bearish in the context of trading. It suggests that an asset's price has risen too high, too quickly, potentially indicating an impending price correction or reversal. Traders often see overbought conditions as a signal to sell, expecting a downward price movement as the market corrects itself.
An oversold stock is considered cheaper than it should be and can be a great opportunity to get a favorite stock at a discount price, though the oversold condition is not an automatic buy signal.
Stochastics are a favored technical indicator because they are easy to understand and have a relatively high degree of accuracy. It falls into the class of technical indicators known as oscillators. The indicator provides buy and sell signals for traders to enter or exit positions based on momentum.
Overbought or oversold conditions in a currency pair can signal an impending price trend reversal. This is since extreme market conditions frequently indicate that a currency's price has risen to an unacceptably high level and that a correction is imminent.
The current reading makes Tesla extremely oversold. Trading Strategy: Buy Tesla on weakness to its monthly value level at $163.34. Reduce holdings on strength to its 200-week simple moving average or “reversion to the mean” at $225.90.
A reading above 70 suggests an overbought condition, while a reading below 30 is considered oversold, with both potentially signaling a top or a bottom is forming.
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