Forex overbought and oversold indicators
Technical analysis of Forex (as well as other exchanges) includes the important concepts of overbought (”overbought“) and oversold (”oversold"). They are used in the process of forecasting and analyzing stock, commodity and currency markets. However, many traders mistakenly interpret these conditions and make poor decisions when the market reaches overbought or oversold. Let's look at the essence of these market conditions.
Consider 2 situations:
There is a situation in the market where the price has risen sharply and high, and we are waiting for it to fall - in this case, the market is called overbought.
The market situation is such that the price has fallen sharply and low, and we are waiting for its increase - in this case, the market is oversold.
It is important to understand that the conditions described above are relevant for the time format selected by the Forex trader. Depending on this, individual reversals may be just pullbacks in the main trend line, and not market reversals. One of the main tasks of a trader is to determine the period of holding positions in order to correctly respond to price fluctuations.
How do I determine overbought and oversold States?
Indicators such as RSI, MACD, DeMarker, Keltner Channel, Stochastic, Momentum, and Bollinger Bands are best suited for determining overbought and oversold conditions. The best results are shown by Bollinger bands, since they allow early entry into the market. Do not forget that the timeframe used also affects the accuracy of determining States. In addition to Forex indicators, you should pay attention to current news signals and the lows/highs of the previous day.
Let's take a closer look at how some of the indicators used work.
Relative strength index RSI
If you need to analyze a wide price range, the best choice for a trader is an oscillating RSI indicator. It allows you to receive signals based on a curve on a scale of 0..100. It is recommended to hold the position until a strong signal indicates the process of reverse movement. Significant signals are formed around the overbought and oversold lines.
Traders are interested in two levels of the line: 30 and 70. If the line passed the 70 mark, it means that the uptrend has come to an end. If the line is close to 30, it is an indication of the end of the downtrend.
Determining overbought and oversold by the Stochastic indicator
The Stochastic oscillating indicator is well suited for determining overbought and oversold levels at early stages. When the indicator is above 80, it is considered that overbought has been reached, and below 20 – oversold, which is used by traders when opening positions. The ideal situation is the moment when high highs and lows appear, which is a sign of the beginning of the opposite movement.
The use of Price Action has a positive effect when working with the Stochastic indicator, since patterns can serve as an additional signal.
Overbought and oversold indicator MACD
The principle of operation of the oscillating indicator MACD is to assess the convergence and divergence in the dynamics of exchange rate changes. The modern version of this indicator contains a histogram and a signal line. Deviation of the histogram from the signal line is a sign of oversold and overbought.
Momentum indicator for non-trend markets
If the market is out of trend, the Momentum indicator is used. It belongs to the class of oscillating, that is, overbought and oversold is diagnosed as the transition of the curve to the maximum or minimum value. It is considered that it is convenient to use the moving average indicator to better understand changes in trends.
A strong advantage of Momentum is that it allows you to determine possible u-turn points before the u-turn facts themselves.
Overbought and oversold indicator DeMarker
The Demark oscillating indicator is used for analyzing both hourly charts and daily timeframes. The key indicators when working with DeMarker are 0.7 (overbought) and 0.3 (oversold).
Like most oscillators, DeMarker defines divergence and convergence. Forex divergence is a situation in which the price reaches its new maximum, and indicators can not confirm this state. Forex convergence is the reverse situation, when the price reaches its new minimum, and this is not confirmed by indicators.
Keltner Channel overbought and oversold indicator
The Keltner Channel indicator belongs to the trend class. Keltner channels are similar in principle to Bollinger Bands, and determine changes in the moving averages. These changes are important for the subsequent prediction of breakouts in the channel.
If the current price is below the moving average, we recommend waiting for it to return to the channel to avoid a false break in the channel.
Similarly, if the current price is higher than the moving average, you should wait for it to return to the channel, because there is a probability of a false breakout.
Bollinger Bands overbought and oversold indicator
It is believed that the use of the Bollinger band indicator gives the best results in the process of market analysis. This indicator consists of 3 bands: upper, lower and Central. When the price reaches the upper band, it is considered that the overbought state has been reached, and the price will soon fall to the Central band. If the price has reached the lower band, then it is oversold, and the price will soon rise to the level of the middle band.
However, it should be noted that the price does not always reach the upper or lower band is an absolute sign of a future reversal – it is recommended to use a different indicator or candlestick patterns for confirmation.
Overbought and oversold conditions are quite rare. Most of the time, the market price is in a weighted average state, i.e. it fluctuates between the maximum and minimum. Separating false market messages from true signals is one of the main tasks of a trader, and it is often misleading for beginners. A competent approach in this case will be a skillful combination of indicators at the right moments, as well as the use of various approaches and Forex strategies in determining the overbought and oversold States.