Understanding 'overbought' and 'oversold'

Believe it or not, it can be all be pretty intuitive. Let’s say you are cooking a chicken in the oven. You set the timer and wait until it’s done. Right, that would be a great scenario if you would have a timer, which you obviously don’t have.

So… you have to check on the bird every now and then to make sure when you take it out it will not be overdone or simply not done at all. In Forex, you are more lucky as you have sort of a timer that tells you exactly if the market is feeling overbought or oversold.

Always remember that it is all about natural reactions. If the chicken is getting burn, you put down the fire or simply remove the chicken. With your positions applies a similar logic.

If the market is overbought, then you should opt for short positions as thing will eventually correct downwards. If the market is oversold, then an upturn is likely to take place.

There are two very useful technical indicators that can help you understand when a pair is overbought or oversold: RSI and Slow Stochastics.

Relative Strength Index (RSI) 

The RSI is a momentum indicator used to compare the magnitude of gains and losses over a specified timeframe to gauge speed and price fluctuations of an underlying security.

Formula:

• RSI = 100 - 100 / (1 + RS)

Where:

• RS = Average gain during X timeframe / Average loss during X timeframe

Stochastic Oscillator 

The stochastic oscillator is a momentum indicator used to compare the closing price of an asset to the average of its prices over a certain timeframe. The sensitivity of the oscillator can be adjusted by changing the period of time used for comparison.

Formula:

• %K = 100(C - L14)/(H14 - L14)

Where:

• C = the latest closing price
• L14 = the minimum of the last 14 trading sessions
• H14 = the maximum of the last 14 trading sessions
• %K= the current market rate of the asset
• %D = three-period moving average of %K