Many novice Forex traders think that all they need to do in Forex trading is Buy in an uptrend and Sell in a downtrend. While this is a general truth, there are many other factors such as overbought and oversold conditions that determine whether a trade ends in a profit or not.
Have you ever asked yourself the following questions?
- How do you know if the price of a currency is too high to go long?
- How do you know if the price of a currency is too low to go short?
- You can make a buying decision in a clear and obvious uptrend; but are you sure the price won’t reverse any time soon?
Overbought and oversold
Today we will look at what it means to be overbought or oversold in a currency pair. If the pair is moving in an uptrend, it may reach a point where no more buyers on the market. At this point, the currency is overbought and the trend is likely to reverse. The same applies to a downtrend. Currency is oversold when the price is too low and there is no more sellers on the market. This will lead to a potential uptrend.
The main concept to remember is that the price of a currency cannot move in one direction forever. At some point, the price must change its direction. This change in direction can occur for many reasons. One important reason is whether the price is overbought or oversold.
A currency pair that is either overbought or oversold may reverse. But it is not always the case. The pair can also remain oversold or overbought for a long time. We can use oscillators to determine if a price reversal is actually going to happen.
Commonly used indicators to identify these states
There are two popular indicators that help traders identify overbought and oversold conditions:
- Relative Strength Index (RSI)
- Stochastic Oscillator
RSI is limited range oscillator which scales from 0 to 100. When the RSI shows above 70, it indicates an overbought situation. If it reads below 30, it indicates an oversold situation. Traders tend to go short when the RSI is at 70 and go long when it is at 30. The RSI is also used in conjunction with other indicators for best results.
Stochastic is simple momentum oscillator which also helps to find overbought and oversold conditions. The Stochastic also has a scale from 0 to 100. A value above 80 indicates overbought, while a value below 20 indicates oversold.
Although both RSI and Stochastic can determine oversold and overbought levels, they have some differences in their underlying theories and methods. Generally, RSI is more useful in trending markets and Stochastic is more useful in sideways or choppy markets.
Getting the maximum profit
Using the overbought and oversold conditions is also important to get the most out of a trade. When you buy exactly at the moment of a downtrend reversal, you will get the most out of the subsequent uptrend. Similarly, when you place a sell order at the very beginning of a downtrend, you are more likely to make the most profit from 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 deep research can help you develop a strategy.
But if you’re looking for an indicator tool that can make your technical analysis work easier, you can quickly take a look at our Pipbreak indicator. It automatically analyzes the market and tells you exactly when to buy or sell. To learn more