Overbought oversold indicator

Overbought oversold indicator
See also

Overbought oversold indicators are the technical indicators used for forecasting and detecting trends on a stock market. It is one of the areas of high importance for stock market researchers and finance professionals. There are several different techniques used for detecting sell/buy points and identifying the trends[1]. Two of the indicators that are most commonly described in the professional literature are:

  • RSI (Relative Strength Index),
  • stochastic indicators.

RSI (Relative Strength Index)

Relative Strength Index has been described and given the formula by J. Welles Wilder JR in 1978. It has been first published in the book New Concepts in Technical Trading System. This indicator has been widely used in multiple areas[2]. RSI pictures price movements change and speed during a set period, it fluctuates between levels from 0 to 100. Volume spikes and price are not always followed by RSI, its role is mainly to track the speed and momentum of the price. RSI level below 20 indicates the stock is oversold which means selling pressure has decreased and we should expect the reversal. When the indicator grows above level 80, it suggests the exhaustion of the upward or buying pressures which means we are dealing with overbought stock and we can expect a reversal in price. Some of the traders use the Relative Strength Index to detect failure swings as well as divergences[3].

RSI is a technical indicator that is relatively easy to apply, this feature makes it popular within users. Its performance is increasing during trendless markets, on the other hand, it tends to be lower when a clear trend can be identified[4].

Stochastic Indicator

Stochastic Indicator, also known as Slow/High Stochastic Indicator, is a momentum indicator that has been developed in the 1950s by George C. Lane. Lane has observed certain relations between stock trading behavior and daily closing prices. Based on these observations, he qualified the overbought and oversold points for the Stochastic value. Same as RSI, Stochastic Indicator oscillates in a fixed range from 0 to 100, values that are below 20 or above 80 are signals for price trend reversal[5].

Two components are constructing the Stochastic[6]:

  •  %K line,
  •  %D line.

The %K line component has values between 0 and 100 and it is computed using the relation between high of the recent price of closing and lowest and highest prices achieved within the certain period. The %D line component is calculated based on the 3 days average of %K line. Described method shows the calculation of fast Stochastic components. One of the main disadvantages of using fast Stochastic is the possibility of causing frequent false signals. Fast Stochastic is the base for obtaining more accurate slow Stochastic and Full Stochastic Oscillator[7].

Footnotes

  1. Sahin, U., Ozbayoglu, A. M. 2014, 240.
  2. Yu, F. 2017, 237.
  3. Halilbegovic, S., Celebic, N., Kulovic D. 2018.
  4. Sahin, U., Ozbayoglu, A. M. 2014, 241.
  5. Hwa, N. E. 2007, 40.
  6. Hwa, N. E. 2007, 40.
  7. Hwa, N. E. 2007, 40-41.

References

Author: Magdalena Wojslaw