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You probably come across these terms on a daily basis reading trade literature and press, but actually what does oversold and overbought mean? And how do you use the existence of oversold or overbought markets in your trading? Every industry or domain has its own language. Or at least some specific expressions. Trading is no different here. If you are a novice, it might be a bit overwhelming at the beginning. But do not worry. We are here to help you understand what it is all about. In today's article, I am going to explain what hides behind the terms oversold and overbought.
Key Takeaways🔑
| →Oversold and overbought markets indicate potential reversals in price trends. |
| →RSI is a popular indicator used to identify oversold and overbought zones. |
| →Using additional tools and techniques can help enhance trading strategies based on oversold and overbought signals. |
What does oversold and overbought mean?
The terms oversold and overbought mean exactly that. The price of the instrument moves extremely low or extremely high and it is said that the asset is being oversold or overbought.
In case of a long and consistent downtrend, without many pullbacks, the price of the asset reaches extreme levels and it is considered to be oversold. A reversal of the trend is soon expected.
We are talking about the asset in the overbought zone when its price is moving constantly upwards and you do not notice many pullbacks during this time. Again, the trend will most probably reverse in the nearest future.
Catching the oversold and overbought areas with the RSI indicator
Oversold and overbought indicators are used to identify areas where the price is “too high” or “too low”. The Relative Strength Index (RSI) is one of the indicators that can help traders to estimate whether the financial instrument is already being oversold or overbought. Its readings are quite simple.
The RSI opens in a new window beneath your IQ Option price chart. It takes a form of a line that moves around. When it reaches below the line of value 30, it means the asset has fallen into the oversold area and an upward movement is expected.
When the RSI moves higher than the line of value 70, the instrument is considered to be overbought and you should prepare for the upcoming downtrend.
Now, the trick is not to rush with opening a trading position. The indicator may continue to move below 30, or above 70 lines for time being. Intending to catch the bottom or the top of this move is pointless. You should wait, instead, for the RSI indicator to cross the 30 line on its way up, or the 70 line on the way down. This is the moment you should enter the trade.
Using oversold and overbought zones in trading
The signals based on the oversold and overbought areas on themselves are not fully reliable. Let's compare them to the hammer which is needed in house construction. Having the hammer is important but it is not enough to build a complete house. Other tools are required too. Now let's go back to trading. Knowing when the asset falls into oversold and overbought areas is very important information however it is not enough to build a trading strategy around this. You need some other tools to strengthen the signals received.
You can take some of the actions listed below to support the signals based on the oversold and overbought zones. But remember that this is not all you can do. These are just some ideas you can expand later on.
Trend identification
You need to learn to identify the trend on the price chart. You will need this not only in correlation to the overbought and oversold zones. Here, you can use the trend to filter for the signals along with it. For instance, during the uptrend, you will filter oversold signals as the points to open a long position. In the downtrend, you will search for overbought signals to open a short trade.
Risk management
This is another crucial point if you are taking trading seriously. You have to take care of your capital and this is the purpose of risk management. Consider the risk to reward ratio and set the stop loss and take profit accordingly.
Sentiment
Utilize client sentiment data to further verify overbought and oversold signals. There is a Traders' Sentiment widget on IQ Option. It displays the current Buy/Sell ratio for the instrument on your chart.
What is better overbought or oversold?
Today the concepts in question are the opposite. It is therefore difficult to say whether an overbought or oversold market is better. It all depends, of course, on whether you want to buy or sell. It is best to buy when the market is oversold and best to sell when the market is overbought.
However, it is important to remember that even the most oversold market can still go down. Likewise, even the most overbought market can continue to go up for some time, thus deepening the overbought market.
Pros and Cons of Trading Oversold and Overbought Markets👍👎
Pros:
- 💡 Identifies potential trend reversals, offering entry and exit points
- 💡 Helps traders avoid entering or exiting positions too early or too late
- 💡 Can be combined with other technical indicators and tools for enhanced accuracy
Cons:
- 🚫 Oversold and overbought signals alone are not reliable enough for a complete trading strategy
- 🚫 Markets can remain in oversold or overbought conditions for extended periods, leading to false signals
- 🚫 Requires a good understanding of technical analysis and risk management to use effectively
Comparison: RSI vs. Stochastic Oscillator📊
| RSI | Stochastic Oscillator |
|---|---|
| Measures the speed and change of price movements. | Compares a security's closing price to its price range over a period of time. |
| Ranges between 0 and 100, with 30 and 70 as the typical oversold and overbought thresholds. | Also ranges between 0 and 100, but with 20 and 80 as the typical oversold and overbought thresholds. |
| Works well in both trending and range-bound markets. | Best suited for range-bound markets but can be adapted for trending markets with adjustments. |
Final word
You already know with certainty what does oversold and overbought mean. Knowing the terms of the trading language is quite important. But knowing what stands behind these terms and how to use them to your advantage is even more important.
I hope this article explained the oversold and overbought areas to you. Train catching the oversold and overbought signals on the IQ Option demo account. You will not risk your own money there. And you can stay there as long as you need to. Nevertheless, you will not make money there either. So practice and move to the live account when you feel ready.
Leave a note in the comments section below. It is designed to share your experience or your doubts and concerns. I am always happy to hear from the readers.
Wish you success!
Frequently Asked Questions🤔
- Q: How do I identify an oversold or overbought market?
A: You can use technical indicators such as the Relative Strength Index (RSI) or Stochastic Oscillator to help identify oversold and overbought zones. - Q: Are oversold and overbought signals reliable for trading?
A: Oversold and overbought signals alone are not fully reliable, and it's important to combine them with other technical analysis tools and risk management techniques for a complete trading strategy. - Q: Can I use other indicators in addition to RSI for identifying oversold and overbought markets?
A: Yes, there are other indicators like the Stochastic Oscillator, Williams %R, and Bollinger Bands that can also be used to identify oversold and overbought conditions. - Q: Is it better to trade in an oversold or overbought market?
A: Both oversold and overbought markets present potential trading opportunities, but it's important to use additional technical analysis tools and risk management techniques to make informed decisions. - Q: How can I improve my trading strategy based on oversold and overbought signals?
A: Enhance your trading strategy by incorporating trend identification, risk management, sentiment analysis, and additional technical indicators to support the signals received from oversold and overbought zones.