A lot of new traders think that forex trading is all about buying low and selling high. While this is true, traders need to consider other factors such as overbought and oversold.
Overbought and oversold are two terms that often appear in forex trading analysis. These two conditions are very important. Every trader should spend some time learning and understanding these conditions because they could assist in reviewing the current price conditions and then formulate some steps to deal with them.
In short, overbought and oversold are terms used in financial markets to describe extreme price conditions of an asset, in which:
- Overbought indicates a significant and rapid price increase, suggesting a potential correction or reversal.
- Oversold refers to a significant and rapid price decline, signaling a potential rebound or reversal.
But before we discuss them further, let's get acquainted with the process behind overbought and oversold in forex trading.
- How Do Overbought And Oversold Happen?
- How to Recognize Overbought and Oversold?
- Why Are Overbought and Oversold Important?
- How to Trade with Overbought and Oversold?
- Trading Overbought and Oversold with CCI Indicator
How Do Overbought And Oversold Happen?
Overbought is a condition where the price has peaked after increasing for some time. The process is as follows:
- A very significant uptrend movement generally precedes this situation.
- After the price increase is sufficient, traders and investors who previously opened buy orders will close positions to make a profit. This specific price point is the very definition of overbought conditions.
- As more and more market participant chooses to close their long positions and does profit-taking, the price will naturally weaken after passing its overbought levels.
- Then, as more traders and investors review their portfolios and decide to end their buy orders, the price decline will occur after the overbought level has been passed.
Meanwhile, oversold is the opposite of overbought. It can happen with the following steps:
- There's a very large push to sell from traders and investors.
- A sharp downtrend formed until the price reached bottom.
- When the price decline is considered too extreme and most market participants profit-taking by closing short positions, oversold occurs.
How to Recognize Overbought and Oversold?
Both overbought and oversold can be identified with the help of an oscillator indicator such as RSI (Relative Strength Index) and Stochastic, which has two extreme standard levels.
If you are trading with the MetaTrader platform, these types of indicators can be displayed in the following ways:
- Open the Insert menu -> Indicators -> Oscillators.
- Select RSI or Stochastic, then click OK.
RSI and Stochastic can measure overbought and oversold but through different standard levels. When using the RSI indicator, the limit is 70 for overbought and 30 for oversold. While for Stochastic, the standards are 80 and 20.
Suppose you are using the RSI, an overbought condition is seen when the indicator chart has risen beyond the 70 level. Conversely, oversold is confirmed when the RSI chart drops past the 30 level.
The observation on the Stochastic indicator is more or less the same, and it's just that the benchmark level is 80 for overbought and 20 for oversold.
Why Are Overbought and Oversold Important?
Because it reflects an overbought condition, overbought is an important signal indicating a potential bearish reversal. Conversely, oversold is interpreted as a marker of a bullish reversal. For this reason, traders often anticipate crossing RSI or Stochastics signals from overbought and oversold levels upon taking a position based on a trend reversal strategy.
How to Trade with Overbought and Oversold?
Say the price is currently going up rapidly but the RSI chart has crossed the 70 level, which means the price will likely reverse down soon. In this situation, the ideal step is to open short positions. Although its main function is to provide entry signals for users who apply trend reversal strategies, overbought can also be used by traders who follow trends (trend followers).
Usually, overbought is an initial signal for trend followers still holding long positions to look for the perfect exit point.
Then what about oversold cues?
Like overbought, oversold signals are an entry requirement for trend reversal strategy users. However, if overbought becomes a sell signal, oversold is used as an indication to open a buy position. If you use the RSI indicator, this signal appears when the indicator chart continues to fall past the 30 levels. At this time, even trend followers will respond by getting ready to end short positions they have held or avoid opening positions because a downtrend continuation signal does not support them.
Watch Out for These Conditions
Even though they are often relied on in forex trading with a trend reversal strategy, overbought and oversold still have risks. To anticipate this, traders who observe these two signals need to consider the following things:
- Overbought and oversold signals for trend reversal strategies work most effectively in sideways conditions. When prices are trending and influenced by very strong market sentiment after the release of big-impact news, overbought and oversold conditions can occur continuously. It may take a long time before they can reverse.
- Don't be in a rush for entries based on overbought and oversold signals. You should use confirmation from indicators or other analysis methods. For example, ensure the RSI chart has moved down from the 70 levels before placing a sell entry on an overbought signal.
- You can also refer to price action signals when overbought or oversold occurs. If the price forms a pin bar or other reversal pattern, then trading entry with a trend reversal strategy can be confirmed. The appearance of such signals will validate your position.
Trading Overbought and Oversold with CCI Indicator
The Commodity Channel Index (CCI) is included in the category of oscillators, which are often used to find momentum. Because it is an oscillator, CCI is also used as an overbought and oversold indicator, and when there is a divergence in the direction of price movement, indicating a possible change in trend direction.
The limits of the CCI level are +100 and -100.
When the CCI indicator curve is above +100, there is an overbought condition which means that the price movement moves up along with the momentum and has deviated from normal fluctuations.
Suppose the CCI indicator curve is below -100. In that case, there is an oversold condition, which means that the price movement moves down along with momentum and deviates from the normal fluctuation.
Thus, the CCI is an indicator that measures the extent to which price has moved from its average value. When CCI is overbought or oversold, the price has passed the normal movement deviation value (standard deviation) from its average. An overbought condition is a signal to sell and an oversold condition is a signal to buy.
The Risks of Using CCI as a Sole Indicator
If you are trading solely on CCI without a combination of other indicators and price action analysis, there will often be error signals or false conditions. This is because CCI is a lagging indicator or an indicator that is always late in responding to price movements. CCI will give a signal after the last closing price. Here's an example:
- False buy signal even when CCI has moved up from the oversold area.
- Correct buy signal.
- False sell signal even when CCI has crossed down the overbought level.
- False sell signal; the price continues increasing even though the CCI is overbought.
- Correct sell signal.
- Correct buy signal.
To avoid errors, traders should combine CCI indicator with price action analysis, moving average indicators (usually exponential moving average or EMA), and support resistance analysis.
Combining CCI with EMA and Price Action
Moving Average is a trend indicator because CCI does not show trend directions. It simply provides traders with information about the strength of the current trend.
With 2 EMA lines, it can be seen that when the smaller EMA period (EMA 9) crosses, the larger EMA (EMA 18) from the top, the price movement will reverse downward.
For a sell entry, we have to wait until the CCI is in the overbought area, which is confirmed by the price action that has been formed. In the example above, the price formation is a Pin Bar.
Conversely, the price movement will reverse upward when EMA 9 crosses EMA 18 from below. So to get the best time to open a buy position, we have to wait until the CCI moves past the oversold area.
Combining CCI with Support Resistance and Price Action Analysis
In this case, the stronger the resistance or support level, the more valid the CCI signal.
In the example above, a sell entry is confirmed when the price is in the resistance area (R1-R2) and the CCI indicator is in the overbought area. As further confirmation, we can see the formation of a Doji at the R1. Conversely, an entry buy can be validated when the price is in the support area and the CCI indicator curve is in the oversold area.
The two trading methods above can be applied at all time frames. Do note that the higher your time frame, the more valid the signal is. One example is trading with the daily time frame.