Relative Strength Index is a popular forex charting tool used in ascertaining overbought and oversold market conditions in technical analysis. RSI measures the magnitude of recent price changes, thus helping technical analysts ascertain the best entry and exit points depending on price action.
The RSI indicator is simply an oscillator that appears as a line graph oscillating between two extremes of 0 and 100. When it comes to analyzing chart patterns, whenever the indicator’s value is above 70, the same is interpreted as overbought conditions. Conversely, whenever the indicator value is below 30, the market is associated with oversold conditions.
The idea in the forex market, whether scalping, trend trading, or news trading is to buy in an uptrend and sell in an uptrend. However, as an essential forex trading secret, it is crucial to ascertain market conditions in either direction.
Similarly, traders should always ask themselves these two questions.
- Is the current price too expensive to open a long position?
- Is the current price too cheap to open a short position?
Overbought conditions occur whenever the price of an underlying asset moves up to a level where buyers consider it to expensive. The lack of buyers to open new positions causes the upward momentum to lose its strength, consequently triggering a price reversal.
Best Forex EA’s, as well as technical analysts, use several forex trading tools to ascertain when the market is too expensive to enter a buy position. Relative Strength Index is a popular charting tool that provides early warning signs that underlying security might have entered the overbought territory.
As a critical RSI strategy, technical analysts, as well as Forex Robots, refrain from opening buy positions whenever the RSI indicator is reading 70 and above. Similarly, it is common to find traders entering short positions whenever the RSI indicator is above 70, given that there is always a high probability of price reversing and starting to edge lower.
During an uptrend, the RSI indicator tends to stay above the 30 marks. However, should the indicator fail to take out the 70 levels, reverses, and then drops below the 30 levels, the same is interpreted as a trend reversal, which indicates the underlying security has turned from being bullish to being bearish.
Oversold market conditions, on the other hand, occurs whenever the price of underlying security drops significantly until there are no willing sellers to open short positions. In this case, security is considered too cheap. Likewise, the lack of sellers to open new short positions often triggers trend reversal resulting in price starting to move upwards.
RSI indicator provides accurate readings to determine oversold conditions. Similarly, whenever the indicators reading is below 30, Forex EA, as well as technical analysts, refrain from opening short positions until a significant reversal occurs. Similarly, technical analysts, as well as FX EA, tend to open long positions whenever the RSI indicator is below 30, given the high probability of a reversal occurring.
In case of a downtrend and the RSI indicator fails to reach the 30 level and then rallies above 70, the same signals that the downtrend has weakened and that the prevailing downtrend has reversed to the upside.
Importance of Overbought and Oversold Conditions
Having a clear understanding of overbought and oversold conditions is an essential money-making hack in the financial markets. With the help of RSI Strategies, traders, as well as forex robots, rely on these conditions to lock in optimum profits.
Similarly, traders develop trading strategies based on overbought and oversold conditions. In most cases, traders enter long positions whenever the RSI indicator is indicating oversold conditions below the 30. Likewise, a short position is opened whenever the RSI indicator is indicating overbought on its reading being above 70.
A security is considered overbought whenever there is a significant and consistent move upward in the price for an extended period. Overbought conditions are synonymous with a lack of buyers to push price further up as security is considered expensive.
Similarly, security is considered oversold, whenever there is a significant and consistent downward move in the underlying price of a security. Such situations are synonymous with a lack of new sellers to push the price of security further downwards. Similarly, security is considered too cheap for also shorting.
A security whose price is in overbought or oversold conditions many at times reverses, in what is often referred to as pullback or correction. However, this is not always the case. Consequently, security can remain in oversold or overbought conditions for a long time. Therefore technical analysts and forex robots rely on oscillators to ascertain whether a reversal is likely to happen.