Author: Floris De Zee
Date of Publication: 14/12/2022
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If you can identify overbought or oversold conditions, as a trader, this can be highly profitable. In particular, these are two definitions that refer to the extreme values of the price in addition to their intrinsic value. So, when these conditions appear, a reversal of the direction of the price is highly expected.
What is Overbought?
When something is ‘overbought’, it means that the price is thriving for a long period of time. Because of this, it’s trading at a higher price than it actually should be. In other words the asset is overly expensive and a sell-off is about to happen.
What is Oversold?
When something is ‘oversold’, it means the price is in a negative momentum for an extended period. Because of this, it’s trading at a lower price than it actually should be. In other words the asset is overly cheap and an upward rise is about to happen.
Indicators of overbought and oversold
Moreover, there’re plenty of technical indicators which you could use in technical analysis. To confirm the Overbought and Oversold conditions the three indicators commonly used are:
Bollinger Bands,
Relative Strength Index and
Stochastics
Bollinger Bands
The Bollinger Bands appear as a channel. Specifically, the middle line is often a twenty-period moving average. On the other hand, the upper band is the moving average plus two times its standard deviation. Furthermore, the lower band is the moving average minus two times its standard deviation. As a result, the price seems to fluctuate in this channel and normally doesn’t move out of the bands. However, when the price tends to move out of the upper band the price can be considered as overbought. Likewise, the same thing happens when the price moves out of the lower band, the price can be considered as oversold.
Relative Strength Index
The Relative Strength Index is a momentum oscillator where the horizontal axis appears as a function of time and the vertical axis as on a scale of 0 to 100. In addition, the standard amount of periods used for this indicator is 14. So, the Relative Strength Index measures the magnitude and the speed of recent price action. The indicator compares a security strength on days when prices go up to its strength on days when prices go down. Yet when the Relative Strength Index has a value higher than 70 the price can be considered as overbought. When the opposite happens and the price drops down a value of 30 the price can be considered as oversold.
Stochastics
Stochastics is like the Relative Strength Index, a momentum oscillator where the horizontal axis appears as a function of time and the vertical axis is displayed on a scale of 0 to 100. However, the stochastic oscillator is predicated on the assumption that closing prices should move in the same direction as the current trend. Meanwhile the Relative Strength Index is measuring the magnitude and the speed of the current price action. The Stochastic oscillator does calculate this value and expresses this value into a %K. In addition, the standard amount of periods used for this indicator is 14. When the %K crosses a value of 80 the price can be considered as overbought. When the opposite happens and the price drops down a value of 20 the price can be considered as oversold.
Combined
One indicator that matches the criteria for being ‘overbought’ or ‘oversold’ can suggest a small trend reversal. But once all 3 indicators combined are matching the criteria, the assumption of a trend reversal is very likely to happen. Therefore, for trading in general this can be a profitable and low risk strategy.
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