Why Using Overbought and Oversold Indicators Is Dangerous
Using overbought and oversold indicators can be really useful, but also very dangerous if not used correctly. We have just added more technical indicator advice, tips and tricks on our website here: https://financialsource.co/why-using-overbought-oversold-indicators-is-dangerous/
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Before I got started with macro fundamentals I started out trading just with technical analysis and the type of strategies I used to like looking at was mean reversion moves, and that meant that I used to have something like 5 or 6 overbought and oversold indicators running on various timeframes looking for opportunities.
Now, there is a reason why I eventually found my way to the fundamentals, because and indicator is lagging and doesn’t tell you where price is going next, it works as a probably indicator which shows where the highest probability of the next move might be, but as everybody knows by now they are not perfect and if you only rely on them I think there is a huge edge that goes missing.
But, talking specifically about overbought and oversold indicators, as I said this is right up my ally from my earlier trading days, and I don’t use any of them anymore, and the reason I don’t isn’t because I think they are worthless, if you use them for the right reason I think they can be very helpful, for me I just prefer not making decisions based on them, and the reason for this is twofold.
Firstly, they can remain overbought and oversold for longer than you can remain solvent. You see, the challenge with overbought and oversold indicators are that they have varying sensitivity to price based on their formula, and even if you have several of them like I used to have, it’s still only giving you an approximation of when something has reached oversold or overbought territory.
And the thing to keep in mind is that it can stay in overbought or oversold territory for much longer than traders often think. The moment you think that price can’t go any further than this, surprise it goes further, because at the point of seemingly overbought or oversold territory you will also have the FOMO crowd trying to catch a move by buying high and selling low, and the only way they make money by doing that is overleveraging that position, and even though that usually can lead to an exacerbated correction, it also means that the upside or downside can be exacerbated before it corrects, and it often goes much further than we think it can or should.
Secondly, massively overbought and oversold moves don’t always lead to a sharp correction. I think this is the most important part so let me just repeat that one more time, massively overbought or oversold prices does not always lead to sharp corrections. Sometimes the price just consolidated before the trend continues, without having a sharp correction.
For example, the EURUSD is a great recent example, if we go to the daily timeframe, let’s add in a basic RSI indicator to the chart. From the month of May we had that initial strong rally to the upside and of course as overbought and oversold indicators started to flash red many participants were calling for a sharp and fast correction, now we didn’t get that, the pair simply consolidated between the 1.14 and 1.12 for a couple of weeks until it resumed it’s move higher.
Same story happened in July, the indicators reached extreme levels and of course lots of participants were calling for a strong correction, because surely now after this move and this move the price can’t go any further without a big sharp correction, and currently we’ve see price move back out of overbought territory after being rangebound for the past few weeks or days.
Now, the pair might still have that sharp correction, will it or won’t it only time will tell, but the point I’m trying to make is that if it does have a sharp correction, it won’t happen because the overbought and oversold indicators said so, because it doesn’t always lead to sharp and strong corrections.
Now of course, there will be times where is does lead to sharp corrections afterwards.
So, to conclude, is it helpful, yeah it can be useful for us to tell us to keep our trades on a tight leash when we are trading in line with the overall trend that’s for sure. But, using it as a signal to trade against the trend I think is dangerous for the reasons explained and like any other indicator should just be used as a guideline and not the basis for the trade.
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