If you are a value investor you have likely looked for opportunities to find currency pairs or indices that moved too far too fast in one direction. These situations occur frequently as market sentiment will often overshoot, pushing prices to unsustainable levels. Fortunately, there is a way to measure when prices move to levels where market sentiment becomes elevated or depressed. By using overbought and oversold indicators you can evaluate the recent movements in prices and analyze if prices are overbought or oversold.
What is Overbought and Oversold
Overbought and oversold refer a level on an indicator that will determine if the market has run too far too fast in one direction. When the market chops around in a tight range, overbought and oversold indicators generally reflect a reading in the middle of the neutral range. Rakuten Securities Australia offers several indicators that can be used to evaluate an overbought or oversold level. A reading that is considered overbought or oversold will vary by indicator. The two most popular overbought and oversold indicators are the Relative Strength Index (RSI) and the Fast Stochastic.
The Relative Strength Index
The Relative Strength Index (RSI) was created by J. Welles Wilder and was featured in his book “New Concepts in Technical Trading Systems” written in 1978. The indicator is a momentum oscillator that measures the rate of change of a price movement. According to Wilder, a reading on the RSI above 70 is considered overbought. Reading on the RSI below 30 is considered oversold. A trading signal on the RSI can be generated based on using the levels, as a stand-alone index or in conjunction with other indicators. The RSI index is considered an oscillator that transverses between 1 and 100.
The calculation of the RSI describes the acceleration and deceleration in price changes. Rakuten Securities Australia through its MT4 trading platform provides software that automatically calculates the RSI on any period. The calculation of the RSI is as follows:
RSI = 100 – 100/1 + RS
RS = Average Gain / Average Loss
The RS is based on the first 14-periods. Which is the sum of the gains over the past 14-periods / 14 and the sum of the losses over the past 14-periods / 14.
Losses are expressed as positive values.
There are several popular ways to use the RSI index. When the RSI prints a reading above 70, the underlying exchange rate is considered overbought. You can see in the chart of EUR/USD that in March of 2020 the exchange rate moved into overbought territory.
One of the issues with the RSI is that an exchange rate can remain in overbought territory for an extended period. One way to compensate for this is to generate a sell signal on an exchange rate when the RSI moves from overbought-territory into the neutral zone. While this signal could be late in some circumstances it tells you when positive accelerating has stalled and negative acceleration could be taking hold.
When the RSI prints a reading below 30, the underlying exchange rate on a currency pair is considered oversold. In February of 2020, the EUR/USD moved into oversold territory. Similar to scenarios where the RSI can remain overbought for an extended period, the RSI can also remain oversold for some time. You can also wait for the RSI to move from negative-territory (below 30) back into the neutral zone to experience a buy signal.
You can also use the RSI as a divergence index. Divergence is a signal of a potential reversal because directional momentum does not confirm the movement in the exchange rate. For example, a bullish divergence occurs when the underlying exchange rate lower low and RSI forms a higher low. This works well when the RSI is below 30. When the exchange rate makes a higher high, but this is not confirmed by a higher high on the RSI, a divergence is formed. This works well when the RSI is printing a reading above 70.
The Fast Stochastic
The fast stochastic oscillator was created by George C. Lane. The Stochastic Oscillator is a momentum indicator. It follows the speed or the momentum of the price. Generally, momentum changes direction before price. The fast stochastic oscillator can be used to identify a future reversal. The oscillating nature of the fast stochastic makes it useful for identifying overbought and oversold levels.
There are three versions of the Stochastic Oscillator. The Fast Stochastic Oscillator is based on George Lane’s original formulas.
The fast stochastic is a bound oscillator that that identifies overbought and oversold levels. The oscillator ranges from zero to 100. Readings on the fast stochastic above 80 are considered overbought while a reading below 20 is considered oversold. These levels can be adjusted to suit your needs and characteristics of the exchange rate or index.
You can see from the graph that the fast stochastic in February of 2020 the index dropped into the oversold territory as the exchange rate declined. Similar to the RSI the fast stochastic can generate a signal as the oscillator leaves the overbought-territory or oversold-territory. Additionally, you can use the fast stochastic as a divergence indicator. When prices continue to slide and make a new low, but the fast stochastic does not make a new low, a bullish divergence occurs. When prices make a new high, but the fast stochastic fails to make a higher high, a bearish divergence occurs.
The Bottom Line
It’s important to remember that it’s more efficient to use both the RSI and the Fast Stochastic in conjunction with other technical analysis tools. This could include support and resistance levels, volume as well as breakout indicators. Remember that prices can remain oversold or overbought for an extended period which makes determining when they are leaving these regions all-the-more important. When the RSI or fast stochastic moves from overbought territory to the neutral range or oversold territory to the neutral range, the decelerating in momentum can be used as a bullish or bearish setup. Additionally, you can use price and momentum divergence to find a place to enter a bullish or bearish trade.