Thursday, February 23, 2012

What Do They Mean by Overbought and Oversold?

The terms are used to describe a market condition that is quantified by certain technical indicators. These indicators are called oscillators with two popular examples being the Stochastics and RSI. An oscillator is a commonly used momentum indicator that measures the current currency price compared to its historical price over a given time period. It looks to gauge the strength and momentum of a currency pair's move by measuring the degree by which a currency is overbought or oversold. The scale for the both indicators is 0 to 100. When Stochastics reaches a value of 80, the market is considered overbought and when Stochastics reaches a value of 20, the market is considered oversold. RSI uses the same scale of 0 to 100, but the value for overbought is 70, while the value for oversold is 30. The idea is when the market reaches either extreme, the chance for a reversal increases.

Buy the Strongest, Sell the Weakest
One important tool FX traders can use in their analysis is the concept of relative strength. I'm not referring to the technical indicator RSI, but rather a comparison of the currencies to determine the strongest currency and the weakest currency. Once we identify those currencies, we can match them up and check the pair that includes both currencies and we should see a strong trending market ("2 Ways to Trade a Strong Trend").


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