Overbought oversold indicator

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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].

Examples of Overbought oversold indicator

  • Relative Strength Index (RSI): This is a technical indicator that measures the speed and magnitude of changes in the price of a security or index. It is used to identify when a stock or index has become overbought or oversold. The indicator compares the magnitude of recent gains to recent losses to determine when a stock or index has become overbought or oversold.
  • Moving Average Convergence Divergence (MACD): This is a trend-following momentum indicator that is used to measure the strength of a price trend. It is used to identify when a stock or index is overbought or oversold.
  • Stochastic Oscillator: This is a momentum indicator that is used to identify overbought or oversold markets. It measures the momentum of a stock or index by comparing its closing price to its price range over a given period of time.
  • Price Volume Trend (PVT): This is an oscillator that is used to measure the strength of a price trend. It is used to identify when a stock or index is overbought or oversold.
  • Bollinger Bands: This is an indicator that is used to measure the volatility of a stock or index. It is used to identify when a stock or index is overbought or oversold.

Advantages of Overbought oversold indicator

Overbought/oversold indicators are a type of technical analysis tool that measure the buying and selling pressure in a security, currency, or asset. They are often used by traders to identify potential entry and exit points for their trades. The following are some advantages of using overbought/oversold indicators:

  • They can provide an indication of when a trend may be reversing, which can help traders to identify potential entry points.
  • They can provide a more objective way to measure market sentiment, which can help traders to avoid emotional trading decisions.
  • They can be used to identify potential support and resistance levels, which can help traders to determine when to enter and exit their positions.
  • They are relatively simple to understand and use, so they can be beneficial to both experienced and novice traders.

Limitations of Overbought oversold indicator

An overbought oversold indicator is a tool that helps traders and investors identify potential buying and selling opportunities. However, there are several limitations to this indicator, including:

  • Misidentification of market cycles: Overbought oversold indicators can misidentify market cycles, resulting in inaccurate readings and potential losses.
  • Lagging nature: Overbought oversold indicators tend to lag behind the market and can be slow to react to sudden changes in market conditions.
  • Failure to account for fundamentals: These indicators do not take into account the underlying fundamentals of a security, such as earnings and news.
  • False signals: Overbought oversold indicators can generate false signals, leading to incorrect investments or trades.
  • Not suitable for all markets: These indicators may not be suitable for all markets, such as currency and commodities, as they may not accurately reflect the underlying market conditions.

Other approaches related to Overbought oversold indicator

There are other approaches that accompany the use of Overbought Oversold Indicators when managing risks.

  • Technical Analysis: This approach is used by traders to determine the direction of the price of an asset by studying the past price movements. Technical indicators such as moving averages, support and resistance levels, and trendlines are used to identify potential buy and sell opportunities.
  • Fundamental Analysis: This approach is used by traders to assess the intrinsic value of an asset by analyzing the underlying factors that might affect its price. The investor considers the company’s financial performance, earnings, management, products and services, and other factors before making a decision to buy or sell the asset.
  • Options Trading: This approach involves the use of options contracts to manage risks. The investor can use options to buy or sell a stock at a predetermined price and time frame. This way, the investor can protect their portfolio from unexpected price movements.
  • Stop Loss Orders: This approach involves setting up a predetermined price level at which the investor will automatically sell their position. This allows the investor to limit their losses if the price of the asset moves in an unfavorable direction.

To manage risks effectively, traders can use a combination of Overbought Oversold Indicators, Technical Analysis, Fundamental Analysis, Options Trading, and Stop Loss Orders. Each approach has its own advantages and disadvantages, and the investor should consider all of them before making a decision.

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.


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References

Author: Magdalena Wojslaw

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