Before we begin to look at what are the best indicators for determining overbought/oversold conditions and how to use them, let's first define what overbought/oversold means.
I define an overbought condition as a situation in which the price level of a currency pair has risen to such an extent that it is overvalued and therefore the likelihood of a pullback is very high. The opposite is true in oversold conditions where price action has fallen to such a level as to justify new buying opportunities due to its' current undervalued state. In simpler terms, we are dealing with an extreme level in price action that as a result we should therefore see a corrective move take place.
What's going on in the markets is that there is a very large imbalance of orders in the same direction and this increases momentum. Eventually those with winning positions will want to take some profit off the table while other investors are seeing a great opportunity to enter the market going against the momentum simply because of the extreme level of the price action. Usually this causes a pullback of around 30 to 60 pips from my experience, but it's also a short lived pullback so don't expect big profits here.
This lesson will describe three separate indicators that I've personally used to determine when the market is overbought/oversold. The first two indicators I will introduce will be RSI and Stochastic. They fall into the class of indicators known as oscillators because they oscillate (fluctuate) between two extreme values. They are also part of a larger category of indicators known as leading indicators because they function in such a way that predicts future price action. They are the most popular and commonly used indicators for determining overbought/oversold conditions. At the end I will discuss what indicator I currently use now for determining these conditions, but let's discuss the most popular methods first!
Leave A Comment
Please sign in to comment.