A trader should know some expressions that are commonly used in the trading world. It might seem a bit complicated at the start. But this is why we are here. To tell you about trading and to support you in becoming a better trader. Today, I will present two expressions to you, overbought and oversold areas.
Contents
Key Takeaways🔑
| →Overbought and oversold areas indicate potential trend reversals in trading. |
| →Recognizing overbought and oversold zones can assist in making informed trading decisions. |
| →Proper risk management and consideration of the overall trend are essential when trading with overbought and oversold levels. |
What overbought and oversold areas are
The price is in constant motion. It sometimes goes up, sometimes down or sideways. The asset is considered to be overbought or oversold in the moments when the price rises or falls to the extremes.
When the price of the asset is rising for some time being without many pullbacks, it reaches extreme values and the asset is being overbought. We can expect that the trend will soon reverse.
In the opposite scenario, when the price is falling to extreme levels and not many pullbacks are noted, the asset is considered to be oversold. Similarly, the trend reversal is very much likely.
How to trade with the overbought and oversold levels
Knowing when the asset falls into overbought or oversold zones is useful in trading. There are some indicators that can be of great help in this task. The RSI is one of them.
Identify the overbought and oversold areas with the RSI
The RSI (Relative Strength Index) is used to recognise the occasions when the asset is in the overbought or oversold zones. How to read this indicator?
You must add the RSI to your Olymp Trade chart. It will appear in the separate window below the price graph. It consists of one line that runs around. There are two important levels which are the level of 30 and 70. The instrument is being overbought when the indicator goes above the 70 line. It is oversold when the RSI falls below 30. In both cases, you can expect that the trend will reverse very soon.
The bad news is that the indicator can run over the line 70 or below 30 for a longer period of time. That is why you should not open the position yet. Do not even try to grab the top or the bottom of this move. Instead, wait for the moment when the RSI crosses one of these lines on its way back to the middle and then open a transaction. Other oscillators like the CCI or the Stochastic can do the job as well.
Strengthen the signals received
Imagine, you are building a house. You have a hammer in your hand. But it is not enough. You will need more tools and equipment to finish the job. Now, the hammer is the information that the asset is being in the overbought or oversold area. It is something, but not sufficient. You need to support the received signals. Here are some examples of what you should do additionally.
Recognize the trend
Identifying the trend is very important not only in regards to the oversold and overbought levels. Being able to recognise the overall trend is a base for most trading strategies. You can filter the signals along with the trend. So in a downtrend, you will look for the overbought signals in order to enter a short trade. In the uptrend, you will filter the oversold signals to enter a long transaction.
Risk management
Risk managementRisk management has to be included in your trading plan. You have to protect the capital you already have and this is why you need to think about the risk you are ready to take. Reflect on the risk to reward ratio and then decide on the levels where to place a stop loss and take profit.
Sentiment
SentimentYou can additionally use the Sentiment indicator available on the Olymp Trade platform. It shows the existing buy-to-sell ratio, and you can verify the overbought and oversold signals with it.
Pros and Cons of Overbought and Oversold Areas
Advantages:
- ✅ Overbought and oversold areas indicate potential trend reversals.
- ✅ Traders can use indicators like RSI to identify these areas.
- ✅ Recognizing overbought and oversold zones can assist in making informed trading decisions.
- ✅ The concept of overbought and oversold provides additional context for market analysis.
Disadvantages:
- ❌ Overbought and oversold levels are not foolproof signals and can lead to false indications.
- ❌ It requires additional confirmation from other technical indicators and analysis.
- ❌ The market can remain in overbought or oversold conditions for extended periods.
- ❌ Traders should consider the overall trend and implement proper risk management strategies.
| Trend | Action |
|---|---|
| Downtrend | Look for overbought signals to enter a short trade. |
| Uptrend | Filter oversold signals to enter a long transaction. |
Summary
With time, you will learn more and more words and expressions that are ordinarily used in trading. Know what the specific terms mean and make use of them.
Go to the Olymp Trade demo account. It is an account free of charge where you can practice any new method or approach. I recommend using it to become familiar with the Relative Strength Index indicator and with utilising it to catch the oversold and overbought zones.
After some training, you will be able to use the overbought and oversold signals in trading, and you should then switch to the live account to earn some profits.
Do you have some experience in trading with the overbought and oversold areas? Are you good at recognising them? Share your thoughts with us in the comments section below.
Q&A – Overbought and Oversold Trading
- Q: How can I identify overbought and oversold areas in trading?
- A: Indicators like the Relative Strength Index (RSI) can help identify these areas based on predefined levels.
- Q: Are overbought and oversold levels always accurate?
- A: No, they can lead to false indications, so it’s important to use additional confirmation and analysis.
- Q: How long can the market remain in overbought or oversold conditions?
- A: The market can stay in such conditions for extended periods, so it’s important to consider other factors.
- Q: What should I do to strengthen the signals received from overbought and oversold areas?
- A: Recognize the overall trend, implement risk management strategies, and utilize additional technical indicators for confirmation.