Why Track Overbought/Oversold Levels

Believe it or not, all of this can be intuitive. Say you’re cooking a chicken in the oven — you can set a timer and wait until it’s done, right? That would be a great scenario if you had a timer. It helps to understand Overbought Oversold Indicator.

So if you don’t have a timer, you need to check the chicken from time to time to make sure it’s fine when you take it out. In forex, you’re in luck, because you have a kind of timer that tells you exactly when the market is showing overbought or oversold conditions.

Always remember that it’s all about natural reactions — if the chicken is burning, it’s because you left it on the heat for too long.

If the market is in an overbought-and-oversold zone, you should look at short positions, since it is likely to correct itself eventually — and if the market is in an oversold zone, a rebound is more likely to happen.

There are two very useful technical indicators that can help you understand when a pair is Overbought or Oversold: the Relative Strength Index (RSI) and the Stochastic Oscillator.

Relative Strength Index (RSI)

The Relative Strength Index is a momentum indicator used to compare the size of gains and losses over a specific time frame, to measure the speed and volatility of price movements.

Formula:

RSI = 100 – 100 / (1 + RS)

Overbought: above the 70 level

Oversold: below the 30 level

Stochastic Oscillator

The Stochastic indicator is a momentum indicator used to compare the closing price to its average price range over a given period, and the oscillator’s sensitivity can be adjusted by changing the time period used for the comparison.

Formula:

%K = 100(C – L14)/(H14 – L14)

C = the last closing price
L14 = the lowest price of the last 14 trading sessions
H14 = the highest price of the last 14 trading sessions
%K = the asset’s current market price
%D = a three-period moving average of %K

Overbought: above the 80 level

Oversold: below the 20 level

Conclusions:

• In forex, for identifying overbought and oversold conditions, the Relative Strength Index (RSI) is a type of momentum indicator that looks at the pace of recent price changes to determine whether an asset is set up to rise or to be sold off.
• The RSI is used by market analysts and traders, alongside other technical indicators, as a way to identify overbought and oversold conditions and to spot possible entry or exit points.
• To identify overbought and oversold conditions: when the RSI crosses above the horizontal reference level of 30, this is read as a bullish signal, and when it drops below the horizontal reference level of 70, this is read as a bearish signal.

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