Overbought and Oversold: Overbalance Indicators
In the endless battle on the market between the bulls and the bears, it’s not always the one that’s more aggressive that wins. The onslaught of one of the parties inevitably leads to an oversold or overbought status of any asset, which in itself is a signal for action.
Let us calculate, without further ado, and see who is right.
Gottfried Wilhelm Leibniz
A number of indicators and oscillators are built on the overbought and oversold statuses — the RSI, Bollinger lines, the Chaikin oscillator, ROC — and they all signal an overbalance of forces in one direction or another.
Relative Strength Index — the RSI
Long ago, in 1978, an article by well-known trader Wells Wilder appeared in the magazine Commodities describing a novelty for the financial market of the time — the RSI indicator (Relative Strength Index). A few years later, Wilder published the book New Concepts in Technical Trading Systems, which revolutionized the world of technical analysis.
The RSI refers to leading indicators or oscillators and has a range of values from 0 to 100 that show the strength of the trend:
- If the trend is upward and its driving force is rapidly gaining momentum, the indicator will tend to 100.
- If the trend is downward and its strength is growing, then the indicator will tend to 0.
The relative strength index, or RSI, is most often used to search for overbought and oversold areas, as well as to determine the trend and kickbacks.
Overbought and oversold areas are market phases in which the indicator is above or below a certain range of values. It is believed that if the RSI is higher than 70, then the market is oversold, and if it is lower than 30, it is overbought.
One should bear in mind that in the overbought or oversold zone, the chart may stay for quite a time. Also, the movement of the graph from any zone does not guarantee its movement in the opposite direction.
Trend movements are usually accompanied by kickbacks, or counter-trend movements, the range of which is several times smaller than the range of the trend itself. Often, traders make mistakes by accepting kickbacks as the beginning of a trend change. This is when the RSI comes to the rescue, helping traders understand whether a reversal has really happened:
- If there is a pullback during a bullish trend, then the RSI should not fall below 20.
- If there is a pullback during a bearish trend, then the RSI should not rise above 80.
- If the RSI breaks through these levels, then the trend is likely to change.
The strength of the trend in the RSI indicator is measured by the cumulative height of falling or growing candles. These values are then, for a certain period, processed by an exponential average (EMA). It turns out that the formula contains the ratio of the average height to the average fall for a certain number of candles.
RSI = 100 — (100 / (1 + U / D)), where
U is the exponential average of changes in growing candles
D is the exponential average of changes in falling candles
Stochastic
The market speedometer, or the Stochastic indicator, was proposed by George Lane, president of Investment Educators, in the 1950s. He offered the community a simple but effective tool to measure the rate of price changes and determine the “boiling points” on the market — the excellent points for opening or closing deals.
The Stochastic graph expresses the relationship between the closing price and the maximum–minimum range as a percentage between 0 and 100. For example, a stochastic oscillator value of 70 or higher means that the closing price is near the upper limit of the range, which allows traders to judge the prevalence of bullish sentiments on the market.
Like the RSI, this chart shows overbought and oversold areas, but they are somewhat wider: 20 for oversold and 80 for overbought. It is important to note that in the phases of a trend, the Stochastic gives a lot of false signals, unlike the RSI.
The best signal from the Stochastic oscillator is considered the divergence of the % D line or the % K line from the price. When the price reaches a new lowest minimum and the oscillator gives a higher minimum, there is a discrepancy, which is a good buy signal. It is recommended to consider only the divergences formed within the overbought and oversold zones, since they are considered more reliable.
Bollinger Lines
The indicator Bollinger bands entered the trader’s toolkit in the 1980s. It is based on statistics: averaging and standard deviations.
The indicator consists of three lines:
- A moving average for the selected period
- The value of the moving average minus the standard deviation (sigma) multiplied by the specified coefficient K
- The value of the moving average plus the standard deviation (sigma) multiplied by the specified coefficient K
The last two lines form a channel in which the price is located most of the trading time.
Bollinger lines effectively define the overbought and oversold zones. Traders who trade trend strategies should take a closer look at the zones where the price goes beyond the indicator. Counter-trend strategies involve the analysis of market segments where the price is close to one of the channel borders.
Special attention should be paid to the narrowing of the trade channel. This phenomenon is usually called the “narrowing of volatility,” and after it, as a rule, there is a sharp movement of the asset in question.
The Chaikin Oscillator
The Chaikin oscillator is named after its author, the famous trader Mark Chaikin. The indicator was based on the work of exchange speculators Larry Williams and Joe Granville, who built their market theory on the concept of volume movement.
The basis of this indicator is Accumulation / Distribution (A/D), or the accumulation distribution line, which allows traders to determine whether an asset is moving with increasing or falling volumes. The oscillator itself is constructed as the difference between the exponential moving averages for a period of 3 and 10 of ADL.
Considering that we are talking about volumes that sellers and buyers use to put pressure on the market, the indicator values are not tied to a scale from 0 to 100, and therefore, there are no clear constants defining specific price levels. The utility of the oscillator revolves around zero, which determines the absolute balance of power between buyers and sellers:
- If the indicator is above 0, then the buying pressure prevails.
- If the indicator is below 0, then the selling pressure prevails.
If the price reaches a new extreme that is duplicated an updated extreme on the indicator, then the trend is more likely to continue. In turn, if the price reaches a new extreme and the indicator is no longer able to update it, then the trend is weaker than it seems and is no longer supported by volumes.
Rate of Change — ROC
The ROC indicator, or Rate of Change, can be considered one of the simplest yet effective oscillators to measure the speed of the market. It is based on only one metric — the closing price — and the ROC shows the percentage increment of the price for a certain period. But why is this indicator so popular with traders and analysts?
Everything ingenious is simple. The indicator reacts to changes on the market situation much faster than other oscillators, since the price is taken into account without averaging. At the same time, the reaction rate of indicators using averaging decreases with an increase in a given period. ROC helps to effectively distinguish trend movements from kickbacks as a period increases. Thus, despite its simple and understandable formula, ROC retains all the advantages and functionality of oscillators.
The RSI, the Stochastic oscillator, the Chaikin oscillator, and ROC are proverbial Swiss knives, multifunctional tools in a simple and ergonomic package. Using them, traders can determine the trends and find divergences and patterns, which will allow them to open or close positions at appropriate times.
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The original story was published on the official Xena Exchange blog
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