Each field has its own specific terms. You will come across many special expressions while trading. And it is important to know their meaning. But do not worry if you are a bit confused at the beginning. We are writing these articles so you may expand your knowledge and be a more skilled trader. Today we are going to take you closer to understanding the terms overbought and oversold markets.
Overbought and oversold markets definition
The market is never static. It may be ranging or trending, but it is always on move. The price sometimes rises very high and falls very low on other occasions. And when it reaches extreme values, we say that the market is either overbought or oversold.
The instrument is considered to be overbought when the price continues upward movement for a long time and is placed extremely high on the price chart. In this case, we expect the reversal of its direction.
We can talk about the asset being oversold when the price falls for a long time without many pullbacks and reaches extremely low values. Also, a reversal of the trend is anticipated.
Using overbought and oversold zones in trading
Now you know what the overbought and oversold areas are. The next step is to learn to use them to your advantage in trading. It might be a good idea to add some indicators to the chart as they help in technical analysis a lot. You can utilise, among others, the Relative Strength Index, the Stochastic or the Commodity Channel Index.
RSI as the indicator of overbought and oversold zones
The Relative Strength Index can be of much help when recognising the movement when the asset falls into overbought or oversold areas. Go to the indicators icon, find the RSI on the list and add it to the chart. A new window with the indicator will appear. You will see a line moving around the middle line of value 50. Then, there are two more horizontal lines at levels 30 and 70. And they are what matters here the most because they show us when the instrument reaches the overbought or oversold levels.
When the RSI line moves below the line marked as 30, we can assume the asset is being oversold. When the indicator rises above level 70, the instrument is considered to be overbought.
As I mentioned before, when the asset is oversold or overbought, we expect a soon reversal in the price direction. However, it can take some time before the reversal occurs. Therefore do not enter the trade at the moment the RSI moves below 30 or above 70 levels. Do so when it crosses these levels on its return to the central line.
Empowering overbought and oversold trading signals
There is never a guarantee in trading. That is why you should do as much as you can to protect your account against losses. One possible way is to get some additional confirmation for the trading signals received. How can you do that?
Catch the trend
It is an important task for traders to be able to identify the overall trend. It is, in fact, used in most strategies. When you catch the trend direction, you can then filter the signals. During the uptrend in the market, search for oversold signals and opportunities to go long. And in the downtrend, seek the overbought signals to go short.
As I said, the risk is always included in trading. You should aim at minimising it. And you can do it by including risk management in your trading plan. So think well through how much you are ready to risk. Calculate the risk to reward ratio and take decisions in accordance with it.
Check what other traders do
There is the Majority opinion widget on the Binomo platform which shows in the percentages whether more traders are buying or selling at that moment. You can use the knowledge about the sentiment in the market to support the signals you have received on the basis of the overbought and oversold zones.
Overbought and oversold levels are just examples of the specific terms you will find during your trading adventure. Learn what they mean and use them wisely.
Always try to confirm the signals you have received. You can, for instance, add the RSI to the chart or the Sentiment indicator.
Remember about the demo account that Binomo offers to its customers free of charge. Moreover, there is no time limit you can use it. So try each new technique or tool in the demo account first. See, whether trading with the overbought and oversold signals brings satisfying results to you. If so, move to the live account to invest real money.
All the best!
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