Overbought indicator: buy or sell?

Technical analysis of financial markets includes two very important concepts - “overbought” and “oversold”.

They are used in forecasting absolutely all markets: foreign exchange, stock, commodities, precious metals and cryptocurrency markets.

At first glance, these two market conditions seem very simple, but traders make many mistakes when interpreting them, which leads to losses.

Together with experts from the international broker NPBFX (NEFTEPROMBANKFX), we figured out what the essence of these two market conditions is.

Let's tell you everything from A to Z in order.

To begin with, we suggest you understand what the essence of these two market states is.

• A market situation when the value of a trading asset has risen sharply and market participants are waiting for it to decline. Such a market is called overbought.
• A market situation when the value of an asset has fallen sharply and market participants are waiting for its growth. This is an oversold market.

Attention! When analyzing, it is important to take into account that the indicated market condition is applicable to the time frame that you are analyzing. For example, on the H4 (four-hour) period your market will be overbought, and on the W1 (weekly) period it will be oversold.

This means that the growth on H4 is just a technical correction, and the main trend continues to be downward. Meanwhile, such a price correction also cannot be ignored, because it may be the beginning of a reversal of the main trend.

How is the state of overbought and oversold determined in the market?

It is best to use technical indicators to determine market conditions. In this article we will look at the most popular ones, which were recommended by NPBFX broker specialists: RSI and MACD oscillators, as well as DeMarker. These indicators are also interesting because they are leading indicators. This means that they can tell you in advance about a reversal movement in the market.

Also, do not forget about timeframes. As we indicated above, they affect the accuracy of determining market conditions. Next, let's move directly to the indicators and consider each in more detail.

RSI oscillator

The popularity of the oscillating RSI indicator among traders is due to the ease of its interpretation. The RSI is also unique in that it is a relative strength index, i.e. in addition to determining whether the market is overbought and oversold, it can determine the strength of the trend and the likelihood of its change.

The oscillator itself does not require complex settings and consists of a field with a scale from 0 to 100, where the RSI line of a certain period moves. Usually the RSI is set with a period of 8. See the figure below:

There are two zones in the oscillator field: oversold - a value on a scale from 0 to 30, and overbought - on a scale from 70 to 100. When the price enters one of the zones, this indicates that the momentum of the movement will very soon begin to fade. In the example above, we applied the RSI oscillator to the four-hour time frame of the GBPUSD currency pair.

We also noted three candles where the oscillator began to change direction in the overbought zone. This is a signal to open a deal to sell the British pound. Please note that after further price declines, the oscillator never entered the oversold zone and after some time began to grow again. This situation suggests that there continues to be a strong upward trend in the market, and all drops in quotes are simply technical price corrections.

MACD oscillator

Another indicator that allows you to determine whether the market is overbought or oversold is the legendary MACD. This oscillator is present on the price charts of probably every second trader, at least. Allows you to perfectly forecast both currency and stock markets, as well as any other markets.

The oscillating MACD indicator consists of a moving average (Moving Average), as well as a histogram, which is displayed in the form of columns. The working field is divided by the zero mark into positive and negative areas of the oscillator. See picture below:

The MACD indicator not only allows you to determine whether the market is overbought and oversold, but also quite accurately signals upcoming price reversals.

- The market is overbought when the moving average and histogram bars are in the positive area of ​​the oscillator, and after active growth, the MACD bars begin to decline. This indicates that sellers are starting to return to the market. You need to focus on the maximum peak values ​​of the MACD histogram, because in the positive region there may also be lower “slides”, which are intermediate values.

- Oversold conditions can be identified at peak values ​​of the MACD histogram in the negative area of ​​the oscillator. That is, everything is the same as when determining overbought, only in reverse.

As for reversal signals, they are defined as follows:

• Sell ​​signal. The MACD histogram bars cross the MA from top to bottom in the positive area of ​​the oscillator. The moving average should also be above the zero mark.
• Buy signal. The MACD histogram columns are decreasing and crossing the MA from bottom to top in the negative area of ​​the oscillator. The moving average is below zero at this time.

On the price chart above, on a four-hour period of the GBPUSD currency pair, we have indicated for clarity such signals of reversal movements in the market. Please note that the MACD indicator in most cases gave a reversal signal at the very beginning of the main price movement.  

Oscillator DeMarker for determining overbought and oversold markets

The DeMarker technical indicator also belongs to the “leading” group. Its peculiarity is that DeMarker signals predict an inevitable change in the current trend in the market. It can be used on any time frame, although it was originally created by the author for the daily period.

The classic DeMarker consists of an oscillator line with a period of 14 in the basic setting, as well as a scale from 0 to 1. The working field of the oscillator is divided into areas: a value from 0 to 0.3 is an oversold area, a value from 0.7 to 1.0 is an area overbought. However, for a more accurate signal, traders narrow these areas, for example, from 0 to 0.1 (oversold) and from 0.9 to 1.0 (overbought).

Important! The DeMarker oscillator is not recommended for use in a flat market, so look for a trend chart for trading.

For example, we took the daily timeframe, as intended by the author of the oscillator Thomas DeMark, and the XAUUSD (gold/US dollar) trading pair. With this we once again emphasize that DeMarker can work in any market. As for the settings for the overbought and oversold areas, we decided to take something in between – 0-0.2 and 0.8-1.0.

As you can see, over three trading months there were only two situations on the chart when the market was in a state of overbought and oversold. However, as expected, the pair’s quotes subsequently reversed. The trader was able to make great money using these two DeMarker signals.

Of course, the reversal does not always happen literally immediately. For example, after the oscillator line entered the overbought area, the price on the chart grew for more than a week, after which quotes collapsed. The situation developed more successfully when the oscillator line entered the oversold area. The market reversal occurred within a couple of days.

Conclusion

Overbought and oversold conditions are not that common in the market. That is why a trader needs to be able to very accurately identify them on a chart. This will allow you to predict reversal movements and enter or exit a trade at the very beginning of the movement.

The indicators presented in the article are only part of what exists on the market. Each indicator is worthy of a separate lengthy article. We recommend studying them thoroughly in order to swim in the topic of overbought and oversold markets like a fish in water.

We should not forget that for effective trading in financial markets it is important to work through a reliable broker. Technical analysis, indicators - this, of course, is all great, but the broker processes the transactions and pays out profits in the same way. For our part, we recommend NPBFX, . You won't have any problems with this broker!