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Determining Overbought and Oversold Conditions Using Indicators

   

overbought and oversold

As a trader, being able to identify overbought and oversold market conditions can help you determine when to enter and exit a trade, what position to take, and when a trend reversal may be imminent. This insight allows you to manage risk and make more informed trading decisions. 

The most popular indicators used to identify overbought and oversold conditions are the relative strength index (RSI) and the stochastic oscillator. Both tools are momentum indicators and are plotted on a separate graph adjacent to that of the price action. They are also banded oscillators and, as such, have a set graphic range between 0-100. Overbought and oversold readings bookend the upper and lower bands, or extremes, of this range.

Using the Stochastic Oscillator to Identify Overbought and Oversold Conditions

On a stochastic graph, readings that fall within the 80-100 range are considered overbought, and readings that fall between 0-20 are considered oversold. The analytical concept of support and resistance dictates that when a price reaches an extreme overbought or oversold threshold, it will reverse. For this reason, overbought stochastic readings are interpreted as bearish (sell) signals because price momentum is expected to move in the opposite direction. Conversely, oversold readings are considered bullish (buy) signals, anticipating a rise in price momentum. 

That said, a reading above 80 or below 20 isn’t necessarily an invitation to enter a trade. In some instances, an asset may remain overbought or oversold for an extended period of time if the price trend remains strong (i.e., the price continues to close at higher highs or lower lows). In the image below, the stochastic oscillator makes a move above 80 (producing a sell signal), but the price continues to rise—and the asset remains within the overbought range for a few days. If the trader had entered into a short position when the oscillator made its initial move above 80, they would have ended up taking a loss or exiting the trade before the trend reversed in their favor.

Image1_Overbought Stochastic Reading

Investing in the direction of the strong trend will limit the amount of risk you incur and protect you from entering into a trade too soon. Before acting on overbought and oversold readings, examine your price action graph and use a trend indicator such as the moving average convergence/divergence (MACD) to confirm the direction and strength of the current trend.

To further validate the buy and sell signals produced by overbought and oversold stochastic readings, traders also look for divergences and signal line crosses. A divergence occurs when the price action reaches a new high or low extreme and the stochastic oscillator fails to follow suit. Typically, a divergence will precede a trend reversal because price momentum (as measured by the stochastic oscillator) is known to shift direction before the price itself. For example, in the image below, the price reaches a new low, but the stochastic oscillator fails to make a lower low than previous readings

Image2_Stochastic Oscillator Divergence

At the point of this divergence, the two stochastic signal lines cross—yet another indication that the trend is primed for a reversal. Before entering into a long position, the trader should wait to confirm a corresponding change in price. Immediately following the divergence, the price fails to make a lower low and continues to climb in the opposite direction, thus confirming the reversal.

Using the RSI to Identify Overbought and Oversold Conditions

Unlike the stochastic oscillator, the RSI does not use a simple moving average as a second signal line and, therefore, cannot be used to identify crossovers. Though the RSI uses a different analytical formula, it also measures price momentum and is used to identify overbought and oversold readings. Although the stochastic oscillator and the RSI have the same graphic range, RSI readings above 70 are generally considered overbought, and readings below 30 are considered oversold (as opposed to 80 and 20 on the stochastic oscillator).

When the RSI climbs above 70 and then falls back below this oversold threshold, it is thought to indicate that the trend will reverse and that the price will drop. Under this premise, the RSI movement is understood as bearish. Similarly, when the RSI drops below 30 and then traverses back above the 30 line, it is understood as bullish, anticipating a corresponding rise in price.

As with the stochastic oscillator, RSI buy and sell signals should always be evaluated within the context of the current trend in order to minimize risk. For example, if a price is forming a strong uptrend, a trader should ignore oversold readings that oppose the current trend until they can confirm a corresponding reversal. Though it is possible to profit by acting on overbought and oversold readings that defy the overall market trend, this strategy requires traders to make quick entries and exits and, ultimately, means taking more risks for less potential reward.

Failure swings are also used to help identify price trend reversals. When the RSI surges above 70, drops below 70, and then increases again without crossing over the overbought threshold, it is considered a failure swing. The same is true when the RSI drops below 30, rises above 30, and then drops again without traversing the oversold line.

Image3_RSI Failure Swings


When to Use the Stochastic Oscillator vs. the RSI

Given the different attributes of the stochastic oscillator versus those of the RSI, it is helpful to know when each indicator offers more value and accuracy than its counterpart.

In general, the stochastic oscillator is a better indicator in volatile markets in which price movements are erratic. Because it doesn’t rely on trending information to indicate overbought and oversold conditions, the stochastic oscillator can offer insights into non-mainstream forex assets for which price movements have little if any correlation to past activity.

The RSI, by contrast, uses this trending information, which makes it a poor indicator to use in situations in which price activity is volatile. But for major currency pairings, it can be a valuable indicator, more so than the stochastic oscillator.

Other Useful Overbought and Oversold Indicators

Parabolic SAR

The parabolic stop and reverse (SAR) is a chart indicator that measures both the price movement and the speed of the price change to identify overbought and oversold positions, making it a valuable tool for those looking to time trades to take advantage of price swings.

The parabolic SAR indicator appears on charts as a series of dots either above or below the pairing’s price, depending on whether the price is trending up or down. If dots appear below the price, it indicates that the pairing’s price is trending up, which could entice traders to open a new position.

The more these dots are spaced out from one another, the more indicative the parabolic SAR is of quick, decisive price movements. As dots move closer to one another, it indicates a slowdown in this momentum—the chart is reaching the top or bottom of a parabola, indicating a likelihood that it will reverse its course.

In the USD/JPY chart below, a parabolic SAR pattern develops at several points—but a single dot at the end of the chart suggests a new price movement that indicates a reversal, and a potential short opportunity for traders:

usd-jpy

 

It is a common practice to use this indicator in conjunction with other overbought and oversold indicators, strengthening your case when making a decision to open a position.

Fibonacci Retracement

Traders are familiar with Fibonacci retracement levels, but these lines of support and resistance can be useful in identifying overbought and oversold positions based on recent chart movements.

The most common use of Fibonacci retracements, in regard to identifying overbought and oversold conditions, has to do with the Dow Theory of retracement. This theory stipulates that when an initial price movement takes place, the price will then usually retrace around 50 percent. This 50 percent mark is right between the 38.2 percent and 61.8 percent Fibonacci retracement levels, which themselves function as the endpoints between a larger “zone” of anticipated retracement.

Traders can get into trouble when they commit themselves to hitting those retracement levels before they close their position and take a profit. Instead, the Dow Theory would suggest that the best use of Fibonacci retracement is to open a position once overbought or oversold conditions develop, and to then target a position within that range of 38.2 percent to 61.8 percent. Once you enter this zone, consider using stop-losses to secure a profit while continuing to chase greater profits through greater retracement.

When assets repeatedly struggle to clear a given line of resistance, it can be reflective of overbought conditions that result in a price drop. Similar to the parabolic SAR, Fibonacci retracement is particularly valuable when combined with other indicators, such as the stochastic oscillator, to affirm the relationship between retracement and overbought or oversold conditions.

In the chart below, a simple ABCD Fibonacci retracement pattern coincides with a stochastic indicator of oversold conditions for NZD/USD:

nzd-usd

If you’re already comfortable using Fibonacci retracement for other chart evaluations, you can also find value in using them to identify overbought and oversold conditions.

Bollinger Bands

Bollinger Bands feature three lines on a chart, all based on the 20-day simple moving average (SMA). This is a simple tool for identifying overbought and oversold conditions for an asset: Whenever the price breaks below the lowest of the three bands, it indicates oversold conditions that may lead to a bounce-back in price.

Conversely, a price break above the highest of the three bands can indicate overbought conditions, which increases the risk of a price decline. This trading strategy is ideal for currency pairs that feature high volatility. 

MACD

The MACD is also capable of providing some insight into overbought and oversold conditions. It illustrates graphically the relationship between both the 26-day and 12-day exponential moving averages, and then plots a signal line on top of the resulting MACD to identify buy and sell opportunities. When the MACD crosses above the signal line, it can signal oversold conditions, encouraging traders to buy. When the MACD drops below that line, it signals overbought conditions and can trigger a sale.

As a centered oscillator, the MACD has no set graphic range. Because of this, it is incapable of providing precise overbought and oversold readings. Instead, the MACD can be used in conjunction with the stochastic oscillator and RSI to confirm a trend‘s strength and help identify divergences. Additionally, many traders consult indicators such as the parabolic SAR to confirm the direction of the trend and determine more precise entry and exit points. 

Rounding Out Your Trading Strategy 

To shoulder the least amount of risk and increase your profit potential, trade in the direction of a strong trend and confirm buy and sell signals across different indicators in your trading strategy. 

As you develop a strategy for using these indicators to assess overbought and oversold positions, this process will become routine for forex traders, allowing you to clearly analyze trade opportunities and giving you the tools to recognize the right time to sell.

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Disclaimer:

The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.

This post was written by Graeme Watkins

CEO Valutrades Limited, Graeme Watkins is an FX and CFD market veteran with more than 10 years experience. Key roles include management, senior systems and controls, sales, project management and operations. Graeme has help significant roles for both brokerages and technology platforms.

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