The market for valuable assets is complex and dynamic, where overbought and oversold zones play a huge role for traders. And with all the importance of defining these terms, 100% accuracy in this matter cannot be achieved, even with the use of special algorithms.
The zones are not identified unambiguously due to multivariate dynamics and a combination of factors that affect the final indicator. These include the magnitude of the amplitude, price fluctuations. Therefore, you have to understand the nature of such processes before trading.
What Are Overbought and Oversold Areas?
If the price has moved far from the average in a certain direction, the formation of an overbought or oversold zone is considered to happen. So, the definition of terms will sound like this:
Overbought is a short-term price deviation into the overpriced area. The asset price forms new local maximums on the charts. If the bulls are raising the price high enough, it is worth expecting that the bears will join the game and correct it, which will lead to a downward movement.
Oversold is a change in the average value of assets towards underestimation. It’s characterized on the charts by the formation of local minimums, after which, an upward correction is expected, which can happen at any time.
How to Form a Right Trade Strategy?
Special indicators help the trader navigate the current state of affairs on the market. The trader receives signals about overbought oversold areas using special indicators. Most of them are pre-built into trading platforms for easy analysis and asset management:
The Stochastic Oscillator shows the deviation of prices from the average as a percentage. It estimates the possibility of bulls or bears interfering in the process when extremes are reached. Signal lines are drawn in the 0-20% area (oversold) and 80-100% (overbought).
RSI is an index that helps to form the correct trading strategy. It shows areas above 70 and below 30.
The DeMarker indicator not only takes into account medium-term lows and highs but also compares them with the data of the previous period, on the basis of which, an assessment of the price chart is formed, where an area below 0.3 is considered an oversold zone, and an area above 0.7 is considered overbought.
Sometimes, it is better to trade with the trend or wait for a correction before trading with the trend, especially if it goes against the signals that you see on the market.