Learning to use these indicators will help you increase your profits. You’ll have a chance to detect an imminent market reversal and open a trade at the very beginning of a new trend.
Difference in Concepts
Let's start with a brief description of these two terms:
- Overbought is the state of the market after a significant stable growth, ready for a downward reversal.
- Oversold, on the other hand, occurs in the market after a significant fall, and an upward reversal is expected soon.
These two concepts show who is currently dominating the market. At the moment of overbought, the bulls are the leading force. The chart is steadily moving upwards. When the market is oversold, bears prevail. They sell steadily and the chart tends to move downwards.
Under any extreme conditions in the market, there is a high probability of a change in the traders’ mood. That is why overbought and oversold conditions give a reversal signal. However, market behavior cannot be predicted with 100% certainty. It is best to use this signal in conjunction with others.
Overbought and oversold data can be found in the RSI indicator. It is a basic free program built into the MetaTrader 4 trading platform. How to use it, read below.
Oversold Market
The RSI indicator is easy to use. You will see an additional curve below the chart that will fluctuate mostly between the 30 and 70 levels. A drop below 30 indicates that the market is oversold, as seen in the picture below.
At the same moment, the chart reached the main support level. The oversold situation in the market signals a further price reversal. Now is the time to go long and enjoy the show.
However, remember that the market does not follow the signals. It works the other way around. It is best to confirm the signal with other signals:
- Formation of reversal candlestick patterns
- Bouncing up from the support level
- Reversal signals of the main trend, etc.
Overbought Market
This condition is a mirror image of an oversold situation. At such times, the market is dominated by bulls and that is confirmed by the persistently growing chart. That’s when you refer to the RSI indicator. When the curve rises above 70, the bears are ready to take the lead and turn the market down.
Still, it’s better to wait for confirmation by other signals. Make sure the chart is in the area of the main resistance line. Wait until the level is broken to the downside and the market closes at least one bearish candle. If there is also a confirming candlestick pattern on the chart at this time, you can safely open a short trade.
These are the main differences between the overbought and oversold concepts. Pretty easy, huh? In the next article, I'll show you how to best apply this knowledge to trading. See you next time!