How to determine the levels of overbought and oversold by using a stochastic oscillator

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Overbought or Oversold? Use the Relative Strength Index to Find Out

The Relative Strength Index (RSI) describes a momentum indicator that measures the magnitude of recent price changes in order to evaluate overbought or oversold conditions in the price of a stock or other asset. Originally developed by noted American technical analyst J. Welles Wilder Jr., who introduced the concept in his seminal 1978 book, “New Concepts in Technical Trading Systems,”   the RSI is displayed as an oscillator, which is a line graph that moves between two extremes. Its reading can range from 0 to 100.

The primary trend of the stock or asset is an important tool used to ensure that the indicator’s readings are properly understood. Well-known market technician Constance Brown has widely promoted the idea that an oversold reading on the RSI that occurs in an uptrend is likely much higher than 30%, and an overbought reading on the RSI that occurs during a downtrend is much lower than 70%. 

Traditional interpretation and usage of the RSI dictates that values of 70 or above suggest that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective price pullback. An RSI reading of 30 or below indicates an oversold or undervalued condition.

Key Takeaways

  • In finance, the Relative Strength Index (RSI) is a type of momentum indicator that looks at the pace of recent price changes so as to determine whether a stock is ripe for a rally or a selloff.
  • The RSI is used by market statisticians and traders, in addition to other technical indicators as a means of identifying opportunities to enter or exit a position.
  • Generally, when the RSI surpasses the horizontal 30 reference level, it is a bullish sign and when it slides below the horizontal 70 reference level, it is a bearish sign.

Overbought and Oversold Levels

In terms of market analysis and trading signals, when the RSI moves above the horizontal 30 reference level, it is viewed as a bullish indicator.

Conversely, an RSI that dips below the horizontal 70 reference level is viewed as a bearish indicator. Since some assets are more volatile and move quicker than others, the values of 80 and 20 are also frequently-used overbought and oversold levels.

How to determine the levels of overbought and oversold by using a stochastic oscillator

The stochastic oscillator is an indicator that is used in trading to determine levels of overbought and oversold. For a trader, this will mean the moment when it will be profitable for him to open and close his trading positions.

Like all other indicators, the stochastic oscillator helps to predict the trader how a certain asset will behave. Invented it was around 1950.

The operating principle of the stochastic oscillator

This indicator is designed to monitor the price momentum. According to the theory tested in practice, the price pulse reacts much better and changes its direction faster than the price itself. With this indicator, we can predict the point at which the trend will unfold. And tracking the trend in trading binary options will be one of the decisive factors.

The stochastic oscillator has a number of features. It itself is the ratio of the last closing price and the range of low and high values ​​for a specific period of time. The idea that underlies the stochastic oscillator – the closing of transactions on an uptrend will have prices higher than the closing of transactions for the previous period. If the trend is downward, the closing prices of deals will be lower than for the previous period.

On the chart, the stochastic oscillator is displayed by two horizontal lines and two moving averages.

– Fast moving average line has a default period of 3, slow – 13

– The stochastic oscillator can range from 0 to 100.

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– Overbought and oversold levels are 80% and 20% by default. They coincide with two horizontal lines.

Overbought will be an asset, the fast and slow moving average of which will be above the 80% level. Assets will be considered as assets with moving averages below 20%.

Do not blindly trust overbought and oversold, because they will not always point correctly to the opening of “Put” and “Call” positions. The asset can be a significant time in both zones, which can confuse many traders.

How to adjust the display of a stochastic oscillator?

It is quite easy to do this. All you need is in the “Indicators” section of the list to select the Stochastic Oscillator you need. Not all brokers have this tool in their arsenal. We recommend that you look at the IQ Option website.

Further in the tab click on the “Configure and apply” tab, if you want to use the indicator with the standard settings, then click the “Apply” button.

If you understand what you are doing and want to use your own settings, at your disposal will be at least periods in percentage terms, as well as levels of overbought and oversold. The indicator should appear under the schedule of prices of traded assets.

How to apply a stochastic oscillator in trading?

A stochastic oscillator, like other indicators, must give signals to the trader for profitable opening and closing of trade transactions. In addition, our indicator allows you to determine the levels of oversold and overbought. How to use this indicator correctly – read further in the article.

Indication of overbought and oversold

Identifying overbought

In fact, we will need to track the downward trend. In what cases will it occur?

– Fast and slow moving averages exceeded the overbought level

– When a rapid moving average crosses the slow one from below.

The second signal is considered to be one of the additional signals, which indicate that the trend will be downward. Below you can see how it can be seen on the chart of the trading platform IQ Option.

Identifying oversold

Here we are already talking about an uptrend. As in the case of overbought identification, oversold will have 2 signals – the primary and secondary.

– Fast and slow sliding intersect below the level of oversold, we can expect an uptrend.

– The rapid sliding crossed the slowest from above. This will be an additional signal that will indicate to us the expectation of an uptrend.

Let’s look visually, using the example of a binary option IQ Option taken from the trading platform.

Discrepancy pointing to the upcoming trend reversal

The discrepancy pulls an indication of a trend reversal. The indicator and the price begin to move in different directions, which can indicate both a reversal in the direction of the upward and downward trend.

As the discrepancy in practice looks, we can see on the example of the charts from the broker of binary options IQ Option.

Conclusion

If you have learned or already know how to use a stochastic oscillator, then for sure you have already performed your technical analysis more than once, much more effectively. A certain advantage of this indicator is its ability to use with other indicators in the trade of binary options. Do not forget to study well all possible consequences of using this indicator. A stochastic oscillator requires careful handling. It is almost impossible to master it in 1 session of trading. So learn to use it best on a demo account.

“General Risk Warning: Binary options trading carry a high level of risk and can result in the loss of all your funds.”

Indicators for Overbought and Oversold Stocks

Identifying stocks that are overbought or oversold can be an important part of establishing buy and sell points for stocks, exchange-traded funds, options, forex, or commodities. An oversold market is one that has fallen sharply and expected to bounce higher. On the other hand, an overbought market has risen sharply and is possibly ripe for a decline. Though overbought and oversold charting indicators abound, some are more effective than others.

Relative Strength Index

Two of the most common charting indicators of overbought or oversold conditions are relative strength index (RSI) and stochastics. Developed by J. Welles Wilder Jr. and introduced in the 1978 book New Concepts in Technical Trading Systems, RSI is a measurement of stock price change momentum. RSI is a range-bound oscillator, meaning that its value fluctuates between 0 and 100 depending on the underlying security performance, and is calculated based on prior periods’ average gains versus losses.

Key Takeaways

  • Overbought and oversold indicators abound, but RSI and stochastics have stood the test of time.
  • Relative strength index indicates overbought conditions when it moves towards 80 and oversold conditions when it falls below 30.
  • While RSI is computed using average gains and losses, stochastics compares the current price to its range over a given period of time.
  • RSI and stochastics are available on most charting applications, and the default setting is 14 periods, which can be days, weeks, or months.

When RSI indicator approaches 100, it suggests that the average gains increasingly exceed the average losses over the established time frame. The higher the RSI, the stronger and more protracted the bullish trend. A long and aggressive downtrend, on the other hand, results in an RSI that progressively moves toward zero.

RSI levels of 80 or above are considered overbought, as this indicates an especially long run of successively higher prices. An RSI level of 30 or below is considered oversold.

As the number of trading days used in RSI calculation increases, the indicator is considered to be more accurate. Therefore, an RSI computed on a weekly chart is more compelling than one on a daily chart. The standard (default) on most charting applications is 14 periods, which can be measured in minutes, days, weeks, months, or even years.

Stochastics

While relative strength index is calculated based on average gains and losses, stochastics compares the current price level to its range over a given period of time. Stocks tend to close near their highs in an uptrend and near lows in a downtrend. Therefore, price action that moves further from these extremes toward the middle of the range is interpreted as an exhaustion of trend momentum.

A stochastic value of 100 means that prices during the current period closed at the highest price within the established time frame. A stochastic value of 80 or above is considered an indication of an overbought status, with values of 20 or lower indicate oversold status. Like RSI, the default setting for stochastics is 14 periods.

The Bottom Line

Both the relative strength index and stochastics have strengths and weaknesses, and the indicators are best used in combination with other tools designed to establish optimal buy and sell points. Lastly, there are times when a stock, commodity, or market can stay overbought or oversold for a considerable time period before a reversal. Therefore, overbought or oversold signals from RSI or stochastics can sometimes prove premature in strong trending markets.

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