Even if you are only new to the market, you probably already got acquainted with such words as overbought and oversold . Today I want to talk about what these concepts mean and how useful they can be to a trader in his forex trading.
The market is driven by supply and demand. Based on this, overbought is a situation in the market when the demand for a particular asset at a higher price decreases and then is practically absent. This leads to the fact that the price stops rising. At the same time, more and more sell orders begin to appear. When their volume reaches a significant level, the price falls. Oversold occurs in the market when the supply of a lower price for a trading instrument first declines and then ceases. There are more and more buy trades. When a significant volume is reached, the price of the asset begins to rise.
In other words, overbought and oversold conditions indicate an overvaluation and undervaluation of an asset. Such situations are observed in the market after a strong upward or downward movement.
The question may arise: how to define them? You can use the appropriate technical analysis tools.
How to identify overbought and oversold levels
There are oscillators for this. There are quite a few of them, but I would recommend using the time-tested Stochastic and MACD.
I personally prefer stochastic.
Let’s look at the graph
For the convenience of identifying the zones we are talking about today, the levels 70 and 30 are used. But another option is also possible: 80 and 20. In the oscillator settings, you can specify those levels that, in your opinion, will better reflect the market situation.
When the price enters the overbought zone, we can consider opening a sell order. If we see that the price is in an oversold zone, then we can look for an entry point to open a buy order. You should open deals when the indicator leaves the zone.
In conclusion, I want to give some advice.
You should not build your trade only on the basis of the position of the price relative to the zones. To make a trading decision, you need to use other technical analysis tools. In addition, one must take into account the fact that the price can be in a zone for a long time that indicates overbought or oversold conditions.
I recommend monitoring situations when the price in the zone coincides with its approach to a strong level. This is a good time to open a trade position.
The trading result can be improved by paying attention to the oscillator readings on different timeframes.