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Overbought/Oversold: Which Indicators Do You Use?

Discussion in 'Beginners Bootcamp' started by Forexwatchman, Dec 15, 2010.

  1. Forexwatchman

    Forexwatchman Sergeant

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    I recently completed a lesson for my own website regarding how to go about determining when price action is overbought/oversold. For the sake of discussion, I thought I'd see if there were any relivant threads here at FPA discussing this topic. I found one thread from 2007 which you'll find here: http://www.forexpeacearmy.com/forex-forum/beginners-bootcamp/51-overbought-oversold.html

    Since that's over 3 years old now, lets start a new discussion about this topic. Share your thoughts below, or ask questions.

    Overbought/Oversold: Using RSI, Stochastic, and Moving Average Envelopes

    Before we begin to look at what are the best indicators for determining overbought/oversold conditions and how to use them, let’s first define what overbought/oversold means.

    Overbought/Oversold Defined
    I define an overbought condition as a situation in which the price level of a currency pair has risen to such an extent that it is overvalued and therefore the likelihood of a pullback is very high. The opposite is true in oversold conditions where price action has fallen to such a level as to justify new buying opportunities due to its’ current undervalued state. In simpler terms, we are dealing with an extreme level in price action that as a result we should therefore see a corrective move take place.

    What’s going on in the markets is that there is a very large imbalance of orders in the same direction and this increases momentum. Eventually those with winning positions will want to take some profit off the table while other investors are seeing a great opportunity to enter the market going against the momentum simply because of the extreme level of the price action. Usually this causes a pullback of around 30 to 60 pips from my experience, but it’s also a short lived pullback so don’t expect big profits here.

    What Indicators Work Best at Predicting Overbought/Oversold?
    This lesson will describe three separate indicators that I’ve personally used to determine when the market is overbought/oversold. The first two indicators I will introduce will be RSI and Stochastic. They fall into the class of indicators known as oscillators because they oscillate (fluctuate) between two extreme values. They are also part of a larger category of indicators known as leading indicators because they function in such a way that predicts future price action. They are the most popular and commonly used indicators for determining overbought/oversold conditions. At the end I will discuss what indicator I currently use now for determining these conditions, but let’s discuss the most popular methods first!

    What is RSI?
    RSI stands for Relative Strength Index. Over some period -hour, week, month, etc (depending on focus) – RSI compares the sum of gains with the sum of losses. RSI is specificly used to identify overbought and oversold conditions in the market. It is scaled from 0 to 100, and typically, readings below 30 indicate oversold, while readings over 70 indicate overbought.

    Trading using the RSI
    One strategy I’ve found worth exploring I got from Investopedia is known as the Ride the RSI Rollercoaster.

    Rules for a Long Trade
    RSI reading must be less than 30.
    Wait for an up candle to form and close with an RSI reading of greater than 30.
    Go long at market on the open of the next candle.
    Place your stop at the swing low.
    Exit half of the position at 50% of the risk and immediately move the stop on the rest to breakeven.
    Exit the rest of the position when one of the following conditions is met:
    Stopped at breakeven.
    Trade first moves into overbought territory marked by an RSI readings of greater than 70 and then eventually drops from that zone. As soon as RSI declines below 70, sell at market on the close of that candle.

    Rules for a Short Trade
    RSI reading must be greater than 70.
    Wait for a down candle to form and close with an RSI reading of less than 70.
    Go short at market on the open of the next candle.
    Place the stop at the swing high.
    Exit half of the position at 50% of the risk and immediately move the stop on the rest to breakeven.
    Exit the rest of the position when one of the following conditions is met:
    Stopped at breakeven.
    Trade first moves into oversold territory marked by RSI readings of less than 30 and then eventually rises out of that zone. As soon as RSI increases above 30, buy at market on the close of that candle.

    In the past I had trouble incorporating this trading strategy with my other indicators, and to be honest I just lost interest in it, although I will say that many professional traders in all types of markets (futures, stocks, commodities) use this indicator so it’s worth knowing about.

    What is the Stochastic Indicator?
    The Stochastic is very similar to the RSI. It is an oscillator indicator and also part of the leading indicators category. The Stochastic uses 2 lines that are similar to the MACD lines in the sense that one line is faster than the other. And just like with the RSI, the Stochastic is scaled from 0 to 100. When the Stochastic lines are above 80, then it means the market is overbought. When the Stochastic lines are below 20, then it means that the market is oversold. You could then pretty much employ the above RSI Rollercoaster strategy with this indicator as well, modifying it to include the crossovers of the red and blue lines, and you would probably have great success. But lets get to what I use to determine overbought/oversold conditions.

    What are Envelopes?
    Envelopes are actually an additional feature that you add to a moving average known inside the MT4 platform as Levels. In my lesson on using moving averages I briefly went into detail about how I use them in my trading. For this lesson I will expand on them a little more.

    Envelopes are also known as standard deviations from the moving average and are represented as such on your chart as parallel lines running along side your moving average. To insert them on your chart, you can simply double click on the moving average you want to use and then click on the “Levels” tab to create the envelopes. What you’ll do is insert both a positive and negative value that are the same number only one is positive (serving as your upper band) and the other is negative (serving as your lower band). So lets say your determining that you want to use 45 as your standard deviation or level. Then you would enter 45 and click add, then enter -45 and click add.

    Here’s an example of what it will look like on your chart:
    http://forex-nation.com/wp/wp-content/uploads/2009/12/Envelopes.jpg

    As you can see, envelopes are similar to Bollinger Bands in appearance and in that you use them to determine the boundaries of the price action. By boundaries I mean the limits to an upward or downward push at which point the market is very likely going to reverse and go back towards the moving average. The essential part in all this is that you set your standard deviation settings so that the bands still catch or contain 90% of the candlestick bodies, otherwise they’re not as reliable at indicating overbought/oversold price action. This means that the value you use will have to change sometimes on a weekly basis in order to account for quite or volatile market conditions.

    The method I use is to choose a timeframe (since the values change depending on the timeframe) and zoom out just enough to where you can see all of the candlesticks for at least a weeks worth of price action. For a lower timeframe you might only be able to include one day’s worth of candlesticks. Then physically count how many candlesticks actually close outside of your envelope bands with the current setting you are using. Then divide that number by the total number of candlesticks for that given period of time. You want to get the setting to where no more than 10% of the candlesticks actually close outside of the envelope bands. Therefore roughly 90% of the candlesticks do close within the bands. Now the next candlestick that closes outside of the bands represents an extreme level of price action thus predicting an overbought/oversold condition.

    Think of envelopes as mini support and resistance lines that tell you how far the price action will stray away from your MA before it must return back towards it (at least an overwhelming majority of the time anyways). These are great areas to take your profit since they predict very well the limits to which any downward or upward move will stall out and probably move back towards the MA. Conversely, you can also consider them a great way to determine where to place a trade that’s in the opposite direction that the market is moving for some minor pip gains (30 to 60 pips as mentioned above).
    I’ve found using envelopes fits my trading style and mentality the best. So as with any new trader who is trying to develop a trading strategy, always keep in mind that what works for some doesn’t mean it will also work for you. Also, I would never recommend you use more than one of these at the same time, because that would be both redundant and would make you more confused since often one indicator tells you it’s time to trade and the other says you should continue to wait. These indicators must be combined with other indicators such as support/resistance lines and pivot points in order to truly see the value they provide us retail traders. You will have far more success incorporating one of these indicators into your trading system, but first explore each one separately to decide what’s right for you.
     
    #1 Forexwatchman, Dec 15, 2010
    Last edited: Dec 15, 2010
  2. Pharaoh

    Pharaoh Colonel

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    Ooooohhhh.... good info. I like it.
     
  3. Forexwatchman

    Forexwatchman Sergeant

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    Thanks for your blessing Pharaoh:D
     
  4. Maluco

    Maluco Private

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    Good info in there on RSI, Sir..

    However, at which timeframe are you referring it to!?

    Overbought in a 15M Chart I presume is not the same as it is in the 1H or 4H Chart.

    Happy 2011.
     
  5. Forexwatchman

    Forexwatchman Sergeant

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    Thanks for the reply Maluco. I can't give you a specific answer because to be honest I hardly ever incorporated RSI into my trading decisions and only applied it to the higher timeframes (4hr and daily). Some things to keep in mind though would be that the lower timeframes are going to give you more false signals than the higher ones, but then your S/L will also be smaller than on the higher timeframes and therefore your losses should be lower. It depends on your money management strategy in that case as to which timeframe you use.
     
  6. Eric Alyea

    Eric Alyea Master Sergeant

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    ??? wake up???


    Wake up and read the reports???
    If you can’t get the
    REAL and have to ask then you are a ................?
    flip surf the time charts.. You are an ADULT! it aint porn, look at the charts... ALL OF THEM

    I wish I could have said that in a kinder-gentler way. I’m working on that.

    FPA is good!

    me maybe not. ... stick with it and you will make money!?

    Sorry let's look at it through your eye's.
    What is the difficulty you have doing different time frames on charts?? I love using the cross hairs on different times to find what is real??
    I apologize for being direct and rude.
    This (FPA) is one of the few places to get to cold hard truth.
     
    #6 Eric Alyea, Jan 12, 2011
    Last edited: Jan 13, 2011
  7. John Bozeman

    John Bozeman Private

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    ^^
    Ouch :)

    Judging off of RSI alone, it is a better overbought/oversold indicator in the Higher time frames like Forexwatchman said. I have thoroughly backtested simple RSI strategies for the EURUSD in the 1 minute, 5 minute, 15 minute, 30 minute, Hourly, and Daily time frames. The higher the time frame the more of a true indicator the RSI is.
     
  8. shaunna75

    shaunna75 Private

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    thanks for the info! additional knowledge for me.
     
  9. Pip Slap

    Pip Slap Recruit

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    How is the Envelope differnet than using bollinger bands? Dont they both accomplish the same thing?
     
  10. luckyvic03

    luckyvic03 Recruit

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    Keeping it simple

    I'm a fan of keeping things simple. I prefer to use pivot points and a simple range indicator or two. I also feel that the timeframe is an essential component. I enjoy using the 15 as a good gauge and then when I want to get a temperature check i flip to a 60. But no matter how many tools you have...it can't compensate for experience.
     

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