Overbought vs. Oversold and What This Means for Traders

Following the next RSI rally, it holds above 30 and then rallies above the recent peak.

Following the surge, which uses up a lot of selling power, the number of those sellers that are still willing to "keep giving away" shares at low "bargain" prices becomes exhausted. The relative strength index and other technical indicators take into account the volume of buys and sells in a stock and assign an index level that reflects the approximate mood of the market. 

Heads, Tails Heads, Heads Tails, Tails You can see here that the out of the 4 possibilities, only once do you get heads twice.

What is 'Overbought' 

An overbought or oversold signal simply triggers us to keep an eye on a trending security to see if it actually does start to go back into the trend. And if that happens, we look at a few other things to validate that this is a good trade.

Like many professions, trading involves a lot of jargon that is difficult to follow by someone new to the industry. Today, we will take a look at what it means for a currency pair to be overbought or oversold, and most importantly, what trading opportunities arise from these situations.

Oversold These two terms actually describe themselves pretty well. Overbought describes a period of time where there has been a significant and consistent upward move in price over a period of time without much pullback. USDJPY Hourly Chart — Overbought The term Oversold describes a period of time where there has been a significant and consistent downward move in price over a period of time without much pullback.

Currency pairs that are overbought or oversold sometimes have a greater chance of reversing direction, but could remain overbought or oversold for a very long time. So we need to use an oscillator to help us determine when a reversal is actually occurring. The premise is simple, however. When RSI moves above 70, it is overbought and could lead to a downward move.

When RSI moves below 30, it is oversold and could lead to an upward move. Relative Strength Index, Overbought and Oversold Levels But, we must be patient before we enter our trades, because sometimes the RSI can stay overbought or oversold for quite awhile.

The worst thing we can do is try to pick a top or a bottom of a strong move that continues to move into further overbought or oversold territory. So we must wait until the RSI crosses back under 70 or crosses back above Relative Strength Index, Overbought and Oversold Levels The image above shows the RSI clearly breaking above the 70 level resulting in an overbought reading, but we do not want to immediately sell because we do not know how far price could continue to rally.

We want to wait until the RSI falls back below 70 and then place our sell trade. This gives us a better entry and a higher probability trade. A bullish divergence forms when the underlying asset makes a lower low and RSI makes a higher low. RSI diverges from the bearish price action in that it shows strengthening momentum, indicating a potential upward reversal in price.

A bearish divergence forms when the underlying asset makes a higher high and RSI forms a lower high. RSI diverges from the bullish price action in that it shows weakening momentum, indicating a potential downward reversal in price.

Divergence can last for a long time. Prices may continue to rise even though the RSI is showing a divergence. Therefore, divergence should not be acted on alone. If there is divergence present, it is wise to wait for the price to break in the direction of the divergence before acting.

Failure Swings Failure swings can also be used to spot price reversals. A bullish failure swing forms when RSI moves below 30, rises back above 30 and pulls back again, but holds above the 30 level. The failure swing is complete when the RSI breaks its recent high; this breakout is interpreted as a bullish signal.

A bearish failure swing forms when the RSI moves above 70, pulls back below 70 and rises again, but holds below The failure swing is complete when the RSI breaks its recent low; this breakout is interpreted as a bearish signal. The trader is waiting for an oversold condition in which to buy, but instead of buying immediately when the RSI moves back above 30, the trader has the option to wait and see if the RSI holds above the 30 level on the next drop.

The reverse would be true for selling at the 70 levels after the RSI has reached overbought conditions. Here is how the RSI looks when making a failure swing. Here's a real-world example in which a stock, in an overall uptrend, drops below 30 on the RSI. It then bounces but then drops below again. Following the next RSI rally, it holds above 30 and then rallies above the recent peak. That is the signal to buy. This makes sense, because the RSI is measuring gains versus losses.

In a downtrend, the RSI will tend to stay at lower levels. During an uptrend, the RSI tends to stay above 30 and should hit 70 often.

During a downtrend, it is rare to see the RSI above 70, and the indicator frequently hits 30 or below. These guidelines can aid in determining trend strength and spotting potential reversals. For example, if the RSI isn't able to reach 70 on a number of price swings in a row during an uptrend, and then drops below 30, the trend has weakened and could be reversing lower.

The reverse is true for a downtrend. If the downtrend is unable to reach 30 or below, and then rallies above 70, that downtrend has weakened and could be reversing to the upside.

 

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Overbought refers to a security that traders believe is priced above its true value and that will likely face corrective downward pressure in the near future.

Overbought means an extended price move to the upside; oversold to the downside. When price reaches these extreme levels, a reversal is possible. The Relative Strength Index (RSI) can be used to confirm a reversal. The Relative Strength Index (RSI) was created by J. Welles Wilder Jr. and introduced in his book, "New Concepts in Technical Trading Systems," published in Wilder was a mechanical engineer. 

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Overbought / Oversold – These terms have got to be the most over-used terms when talking about the markets. Overbought refers to the time in which the prices have risen to a level that seems as if they cannot go any higher. Oversold is the opposite, prices have dropped to a point it seems as they cannot go any lower. Overbought and Oversold. Today, we are going to look at what it means for a currency pair to be overbought or oversold. If a pair is moving in an uptrend, it may reach a point where there are no more buyers left on the market. At this point, the currency is overbought and the trend will most likely reverse. The same applies to a downtrend.

Overbought vs. Oversold. These two terms actually describe themselves pretty well. Overbought describes a period of time where there has been a significant and consistent upward move in price over a period of time without much pullback. Determining whether a market is oversold is difficult and is subject to individual interpretation. Oversold. A stock, a market sector, or an entire market may be described as oversold if it suddenly drops sharply in price, despite the fact that the country's economic outlook remains positive.

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