A lot of new Forex traders think that all they have to do in Forex trading is to Buy in an Uptrend and Sell in a Downtrend. While this is a general truth, there are a lot of other factors like the overbought and oversold conditions which determine whether a trade is going to end in profit or not.
Have you ever asked yourself the following questions?
- How do you know whether a currency’s price is too expensive to open a long position?
- How do you know whether a currency’s price is too cheap to open a short position?
- You may decide to buy with a clear and obvious uptrend; but are you sure that the price is not going to reverse soon?
Overbought and Oversold
Today, we are going to look at what it means for a currency pair to be overbought or oversold. If a pair is moving in an uptrend, it may reach a point where there are no more buyers left on the market. At this point, the currency is overbought and the trend will most likely reverse. The same applies to a downtrend. A currency is oversold when the price is too cheap and there are no more sellers left on the market. This will result in a potential uptrend.
The basic concept to remember here is that the price of a currency cannot move in one direction forever. At one point, the price must definitely change its direction. This change in direction can happen for a lot of reasons. One important reason is whether the price is overbought or oversold.
A currency pair that is either overbought or oversold can possibly reverse. But this is not the case all the time. The pair may also stay in either oversold or overbought condition for a long time. We can make use of Oscillators to determine if the price reversal is actually going to occur.
Commonly Used Indicators to Identify These Conditions
There are two popular indicators which help traders identify overbought and oversold conditions:
- Relative Strength Index (RSI)
- Stochastic Oscillator
RSI is a range bound oscillator which is scaled from 0 to 100. When RSI reads above 70, it indicates the overbought situation. If it reads below 30, it indicates the oversold situation. Traders choose to go short when the RSI reads 70 and they choose to go long when it reads 30. RSI is also used in combination with other indicators for best results.
Stochastic is a simple momentum oscillator which also helps to find overbought and oversold conditions. Stochastic is also scaled from 0 to 100. The reading above 80 indicates that the pair is overbought and the reading below 20 indicates that it is oversold.
Even though both RSI and Stochastic can determine the oversold and overbought levels, they have some differences in underlying theories and methods. Generally, RSI is more helpful in trending markets and stochastic is more helpful in sideways or choppy markets.
Getting A Maximum Profit
Utilizing overbought and oversold conditions are also important in getting the maximum profit out of a trade. When you buy exactly during the time a downtrend reverses, you will get the best out of the uptrend that follows. Similarly, when you place a sell order right at the beginning of a downtrend, you will more likely get the maximum profit pips out of that trade.
Traders can develop their own trading strategies based on overbought and oversold conditions. A good understanding of how overbought and oversold oscillators work and doing a deep research can help you in developing the strategy.
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