“Overbought” and “Oversold” are the terms we use in our analysis and articles very often. I am usually asked what I mean by “overbought” and “oversold”. I searched and found out that there was only a small and defective article about these important terms on LuckScout, so that I decided to write a more detailed article about this topic to help traders understand what these terms are exactly.
There are some too technical definitions for overbought and oversold over the Internet. I am going to simplify them as much as possible, and tell you that market is overbought when a few (3 to 5) relatively strong bullish candlesticks, and is oversold when a few relatively strong bearish candlesticks are formed.
I am going to show you how RSI determines that a market is overbought and oversold. Novice traders can add this indicator to their charts and see how it works. Later in this article, I will tell you that although having a good indicator like RSI is a big help to confirm the trade setups we locate, we don’t have to have it on our charts because candlesticks tell us everything we need to determine whether a trade setup is good and strong or weak and questionable. Additionally, you will see that RSI is not able to warn us in advance, if a market wants to go against us to hit the stop loss even after a too strong trade setup.
I have already published a few articles about RSI on LuckScout. I recommend you to read them to know what RSI is and how it works:
- RSI Support and Resistance Breakout
- RSI Divergence and Convergence
- The Importance of RSI 50 Level to Confirm the Trade Setups
RSI is a good indicator in general. Although I don’t use it personally, if I wanted to use an indicator one day, it would be RSI and MACD. Read the above articles and you will know why.
The other thing you have to take into consideration is that when we say a market is overbought, it doesn’t mean that it will reverse and go down. It can keep on going up for such a long time, even when it is overbought. Similarly, price can keep on going down when it is oversold, and being oversold doesn’t mean that it will reverse and go up.
Does it means that we can buy even when the market is overbought, and sell even when the market is oversold?
If we do this when we are at the beginning of an uptrend, then the answer is yes. When an uptrend is started, market becomes overbought after forming a few bullish candlesticks, but then it will keep on going up, and it forms an uptrend. Some bearish candlesticks also form, but they can not take the price down and make the market oversold, and the uptrend will be continued. Therefore, if you know that you are at the beginning of an uptrend, and so you enter the market, you will make a lot of profit.
It is also the same when the market is oversold. We can go short when the market is oversold, and the price will keep on going down in case we are at the beginning of a strong downtrend. The only thing we need is that we know whether we are at the beginning of a downtrend while the market is oversold or not.
With Double Bollinger Bands Trading System, usually we go long when the price has already moved up a lot and the market is already overbought. That is why I always say that trading is not about buying low and selling high. In most cases, it is buying high and selling higher.
In our regular trading system (candlestick patterns + Bollinger Bands), we usually enter sooner when the market is not overbought or oversold. However, as we only take the too strong trade setups, we can catch a trend while we are already in. We find out that we are riding a trend usually when the price breaks above a resistance (in case of an uptrend), or below a support (in case of a downtrend), while we have already taken our positions based on a too strong candlestick pattern. I will show you some examples later in this article.
RSI Is A Good Overbought Oversold Indicator
Add RSI to EUR/USD daily chart and set it to 9. RSI default setting is 14, but we set it to 9 to have sharper highs and lows.
There are three horizontal lines or levels on RSI indicator window: 30, 50 and 70
A market is considered overbought when RSI breaks above the 70 level, or keeps on moving around it, or above the 50 and below the 70 levels:
A market is considered oversold when RSI breaks below the 30 level, or keeps on moving around it, or below the 50 and above the 30 levels:
How Does This Help Us to Trade?
I know you are saying, “so what? Let’s say we learned what RSI overbought and oversold mean. Can it help us to trade and make some money? Can it helps us to enter the markets with a better price? Can it help us to take stronger trade setups and avoid the weak ones?”
It is a big help and confirmation for the trade setups, both with our regular candlestick pattern + Bollinger Bands system and also with DBB System. However, it is not necessary to have it on the charts. Let me show you some examples.
With our candlestick pattern + Bollinger Bands system, usually the too strong short trade setups form when RSI has already broken above the 70 level sharply, but when the short trade setup forms (for example when the second candlestick closes in a too strong Bearish Engulfing Pattern), RSI also breaks below the 70 level.
What does this RSI strong reaction mean?
It means the market has become too overbought, and it was the time for bulls to take a break, because they are exhausted. Now, if a too strong bearish reversal pattern, like a too strong Dark Cloud Cover or Bearish Engulfing Pattern forms, it means bulls want to give the control to bears.
The below screenshot is showing you 4 good examples at the same time. The first three (at the left side of the chart), are weak short trade setups and the last one is a too strong short trade setup. With the first three setups, although RSI had broken above the 70 level, the candlestick patterns are not too strong by themselves. Therefore, they have to be ignored. With the last trade setup, RSI has not only broken above the 70 level more strongly and sharply, but also the Bearish Engulfing Pattern formed by 2013.02.04 candlestick is too strong. Therefore, this is a too strong short trade setup while the market is strongly overbought:
An example of a strong long trade setup:
Now, some examples from the Double Bollinger Bands System.
As I mentioned earlier, we enter the market based on a DBB system trade setup usually when the price has already moved a lot. DBB system is good when we miss a trade setup formed based on our regular candlestick pattern Bollinger Bands system because it shows us another chance to enter the market.
As I mentioned earlier, the price can go much higher, when the market is already overbought, and visa versa. Usually when a DBB long trade setup forms, the market is already overbought. The below screenshot is related to a recently formed DBB long trader setup on GBP/JPY daily chart, while a too strong long trade setup was already formed on the weekly chart, based on our regular trading system. The DBB long trade setup on the daily chart was a good chance to go long, for those who had missed the weekly long trade setup.
As you see on the chart below, candlestick #3 formed a DBB long trade setup while RSI was so close to the 70 level. And when the next candlestick opened (which is actually the right time to go long after the DBB setup was formed), RSI also broke above the 70 level. As you see, the price went up strongly while the market is too overbought. It is possible that it goes even higher:
You go long based on the Candlestick Bollinger Bands system when the market is already oversold, and you go short when it is already overbought.
You go long based on the DBB system when the market is already overbought, and you go short when it is already oversold.
What does it mean?
To take a position, you need a too strong and good trade setup. It doesn’t matter if the market is overbought or oversold. When there is no trade setup based on any of our trading systems, it is risky to go long when the market is overbought, and it is risky to go short when the market is oversold because the price can reverse at any time.
Also when there is no strong trade setup based on any of our systems, it is risky to go long when the market is oversold because it can keep on going down. It is also risky to go short when the market is overbought because it can keep on going up.
It is only a too strong trade setup based on the only real time indicators (candlesticks) that tell you whether you should go short or long. As an overbought and oversold indicator, RSI can only be used to confirm a trade setup, but if you really take the too strong trade setups, you don’t have to get any confirmation from RSI. The price can still go against you, even when RSI has already confirmed the trade setup. The only thing that can save us from losing money, and help us have more winning trades is the candlesticks that are the only real time indicators.