The most successful traders discover overbought and oversold conditions using relatively simple oscillator technical indicators to determine the signal. Each measurement has its strengths and weaknesses but, like most indicators, they are strongest when used in tandem and with other useful indicators such as MACD. These indicators of price reversals and extremes is an ‘oscillator’ which means that the signal line varies over time within a band (above and below a centre line, or between set levels). The efficient market hypothesis says that it’s impossible to "beat the market" because forex market efficiency causes existing prices to always incorporate and reflect all relevant information. However, because markets over-react to additional information, there is some value in taking advantage of this price behaviour. I find that this type of indicator is most effective on the daily chart.
The major downside to using this extreme condition indicator is that conditions can remain… extreme and for far longer than predicted. Moreover, conditions can become even more extreme leading to potentially severe FX drawdowns; another reason to trade with a small percent of equity. This issue can be partially mitigated by trading with momentum indicators. An important rule is to never trade predicting the end of a trend. Sure, the markets can turn on a dime and you might miss a trade entering at the very top or the very bottom, but you don’t have a crystal ball so don’t even try it. If you think a pair is oversold or overbought, fine jump in, but patiently wait until you have confirmation from other sources.
My favourite and most relevant to forex oscillator technical indicator is the Commodity Channel Index. The CCI is calculated as the difference between the typical price of a commodity and its simple moving average, divided by the mean absolute deviation of the typical price. A word of warning when using this indicator: do not consider the price oversold or overbought when the price pops out of the band – trade the signal only when the price moves back into the band.
The relative strength technical indicator (RSI) is another oscillator. It compares the magnitude of recent gains and losses over a specified time period to measure speed and change of price movements of a security. It is especially good for noting signal and price movement divergence. Divergence occurs when a security makes a new high or low in price level but the RSI does not make a corresponding new high or low value.
A technical indicator used by bank analysts is the slow stochastic oscillator. This is a two-in-one indicator that shows the location of the close relative to the high-low range over a set number of periods. Generally, the area above 80 indicates an overbought region, while the area below 20 is considered an oversold region. A sell signal is given when the oscillator is above the 80 level and then crosses back below 80. Conversely, a buy signal is given when the oscillator is below 20 and then crossed back above 20.
A crossover signal occurs when the two lines cross in the overbought or oversold region. A sell signal occurs when a decreasing %K line crosses below the %D line in the overbought region. Conversely, a buy signal occurs when an increasing %K line crosses above the %D line in the oversold region. This indicator is also good for discovering divergence and indicates slowing momentum. For example, a bullish divergence forms when price make a lower low, but the Stochastic Oscillator forms a higher low.
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