Overbought and Oversold

Often, when we check the market analysis for the day, the term overbought and oversold is included in the analysis. But what does it really mean and how will you discern which is which? How will it affect the market movement?

By definition, Overbought refers to a situation wherein the demand for the currency pairs exceeds what is expected of it, resulting to a very significant movement, which can no longer be supported by the fundamentals. It is a sudden upward movement of the currency that surpasses its acceptable level. On the other hand, Oversold means that the price had a drastic fall and its level is beyond what is expected. It is usually an effect by the market overreaction or panic selling.

Now that we have provided its definition, how can we know if a currency is overbought or oversold? In technical analysis, there are is a type of technical indicator which detects whether a pair is overbought or oversold. They are called Oscillators.

Oscillators are technical indicators which measures the momentum through the use of its price compared to its historical price within a given time period. The most famous indicators of this kind are the RSI (Relative Strength Index) and Stochastic. The indicators, after inserted to a chart, will displaythe market movement within a scale of 0-100. In the case of Stochastic, if the indicator goes beyond the value of 80 then the pair is overbought. Meanwhile, if it goes below 80 then the market is considered to be oversold. But in the RSI, the overbought value is 70 and the oversold value is 30.

What happens if it does push through those values? The longer the indicator exceeds those values, the higher the chance of a reversal. But please take into account that a pair may sustain an overbought or oversold status for a long time especially on a strong trend. So it must only assist your main trading strategy by signaling when a reversal might occur.

Stephen Stevenson