Most oscillators have two areas of extremity that show overbought and oversold levels. Conventional wisdom dictates that investors buy when the price reaches the oversold area and sell when the price reaches the overbought area.
While this sounds quite logical, the question remains: If trading the levels was this simple and straightforward, why doesn’t everyone buy and sell them? The answer is, that they don’t work all the time. Therefore, the answer to the question in the lesson title is: yes, they may work, but only under certain conditions.
Overbought and oversold levels in ranging and trending markets
There is a distinction between how to handle overbought and oversold levels, depending on the type of market at the time. Buying oversold and selling overbought levels typically work best in ranging markets. Below is an example:
This is the USD/JPY hourly chart showing the Relative Strength Index (RSI) oscillator in a separate window at the bottom. The standard interpretation of the RSI is to sell overbought levels (RSI > 70) and buy oversold levels (RSI < 30).
This interpretation often works well, but with one condition: the market must be ranging. In the above case, the range lasted for quite some time; long enough to provide 11 short and long investment possibilities from both the overbought and oversold levels. However, things change when the price breaks the range; in other words, when the price starts trending.
The same USD/JPY pair from above broke out of its range and moved higher. This time, the RSI will continue showing overbought conditions, but selling from these levels can be risky because we do not know how far price could continue to rally.
Most investors wait until the RSI falls back below 70 before placing their sell trade. This gives them a better entry point and a higher probability trade.
Selling at overbought levels or buying at oversold levels simply won’t work in trending markets. Hence, a new approach is needed.
This approach utilizes the price action in the RSI oscillator window. Here’s how to utilize it:
- Find the middle of the oscillator’s range and draw a horizontal line to mark it (in this case the 50 level).
- Observe what the oscillator does below the 50 mark. Can it reach the oversold level? If not, and it crosses back above the 50, investors go long expecting the market to make another move higher and the RSI to reach the overbought level again.
- Rinse and repeat for the duration of the trend.
All in all, overbought and oversold levels are great tools to use in technical analysis. Some investors look for divergences in the levels in order to take positions opposite to the market. However, caution is needed, as the market may remain overbought or oversold longer than an investor can remain solvent. Furthermore, it can stay divergent longer than an investor has free margin in their trading account. Therefore, overbought and oversold levels should be taken with a grain of salt and used only if a market is ranging.
- Overbought and oversold levels refer to oscillator trading.
- They work great in ranging markets.
- The market may remain in overbought and oversold levels longer than an investor can remain solvent.
- Overbought and oversold levels don’t work in trending conditions.