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Defining Overbought & Oversold

 

“The market is a device for transferring money from the impatient to the patient.”

- Warren Buffet

What is Price Momentum?

In technical analysis, price momentum is continually measuring an asset’s price differences over a fixed interval of time. Momentum measures the rate at which prices rise or fall. It is a very similar to a train. A train does not accelerate immediately. It moves slowly when it starts, gradually picking up speed until it decelerates towards the end of the ride.

Asset prices bear an uncanny resemblance to how a train moves. As investors, the aim should be to ride the train until prices either decelerate or reverse direction.

What Tools Can We Use to Analyze Momentum?

The most widely utilised technical trading tools to analyse momentum are oscillators. Momentum oscillators measure the rate of change in an asset's price. As prices rise, momentum increases. The faster the rise in the security’s price, the greater the increase in momentum.

Once this rise begins to taper, momentum will also slow. However, decreasing momentum in the face of a sideways trending market is not necessarily characterised as a bearish signal. It simply indicates that the directional momentum is slowing.

How Can the RSI be Used to Understand Extreme Price Movements?

The Relative Strength Index (RSI) is arguably the most popular momentum oscillator across any financial market. This indicator compares the magnitude of an asset's recent price gains to the magnitude of its losses, and transforms that information into an indicator that fluctuates between 0 and 100. At 0, an asset is considered highly oversold, whereas 100 implies that the asset might be highly overbought. The 14-period time frame is generally used as the default time frame when calculating the RSI.

With a Standard Account from FXTM, traders can add the RSI oscillator to the charts accompanying the MT4 trading platform. All you have to do is set two parameters:

  • Select the number of periods used to calculate the RSI (default is generally 14-periods).
  • Determine the preferred appearance including colours, thickness and more.

How Does the RSI Fit into a Strategy?

Technical trading signals generated by the RSI can be broadly classified into the following categories:

  1. The RSI is regarded as being overbought when above the 70-mark and oversold when under 30. However, these levels should not be viewed as absolute rules. Each market is characterised by its own unique dynamics, which may result in different areas acting as overbought/oversold zones. For instance, if any asset is repeatedly crossing above 70, the overbought level might be raised to 80. The reverse can be true in events of oversold assets.
  2. The RSI, in common with price charts, often has the tendency to form chart patterns. The most common among these are double tops and double bottoms. Trendline and support-resistance analysis is also applicable to RSI and may help with early entry into a trend.
  3. Another highly reliable RSI signal is when prices make a fresh high or low, which isn't confirmed by the RSI. These situations are called “Divergences”. Often, after the first sign of weakness in the RSI traders can initiate sell positions below the last major low. Contrarily, when the RSI is positively diverging, any close above the most recent high can be used to establish buy positions.

Benefits of the RSI

  • The RSI is a great method for characterizing momentum and defining opportunities to trade assets when prices have made outsized directional moves.
  • RSI “buy” and “sell” signals also tend to be relatively early compared to other popular technical indicators.
  • Since the RSI generates many signals, it is best applied to range bound, or horizontally trending markets. The RSI can also be advantageously used in trending markets - but usually in the direction of the broader market trend, not against it.

Drawbacks of the RSI

  • Early signals open the possibility of higher returns, but are accompanied by higher risks.
  • Since the RSI provides many “buy” and “sell” signals, the possibility of false signals also climbs.

A Few Final Thoughts On the RSI

Besides being a measure of momentum and understanding when an asset has reached overbought or oversold levels - making them ripe for reversals and pullbacks - the RSI can also be an effective tool for identifying broader market trends. The indicator is most effective when used in conjunction with other technical trading tools such as chart patterns, support/resistance levels, trend identification and candlestick formations.

By being aware of the broader market picture, RSI signals can help put extreme or outsized moves into context. RSI signals and readings can have different meanings in different market circumstances. However, by using other analysis techniques in conjunction with RSI readings, the ability to reproduce potentially successful outcomes can be greatly improved.

Disclaimer: This written/visual material is comprised of personal opinions and ideas. The content should not be construed as containing any type of investment advice and/or a solicitation for any transactions. It does not imply an obligation to purchase investment services, nor does it guarantee or predict future performance. FXTM, its affiliates, agents, directors, officers or employees do not guarantee the accuracy, validity, timeliness or completeness of any information or data made available and assume no liability for any loss arising from any investment based on the same.

FXTM is an international online forex broker offering financial services in forex, CFDs on spot metals and CFDs on Commodity Futures, Indices and Shares.

FXTM brand is authorized and regulated in various jurisdictions. ForexTime Limited (www.forextime.com/eu) is regulated by the Cyprus Securities and Exchange Commission with CIF license number 185/12, licensed by the Financial Sector Conduct Authority (FSCA) of South Africa, with FSP No. 46614. The company is also registered with the Financial Conduct Authority of the UK with number 600475. Exinity Limited (www.forextime.com) is regulated by the Financial Services Commission of the Republic of Mauritius with an Investment Dealer License bearing license number C113012295. Forextime UK Limited (www.forextime.com/uk) is authorised and regulated by the Financial Conduct Authority, firm reference number 777911.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 90% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.”

@2019 FXTM
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