An oversold condition is a technical indicator that forex traders use to predict future price movements.
It simply indicates a situation where the price of a particular asset drops so low for a prolonged period that its momentum turns extremely weak and unable to maintain this pattern anymore.
Going along with this, and similar to other indicators, it means that the market, in general, may turn around and move back up again.
Several different indicators can be used to predict whether or not a currency pair might experience an oversold condition.
One such method of predicting when the conditions could potentially arise would be if you see prices trading below their support levels (in both long term and short term charts) yet moving within a downward channel.
Generally speaking, longer-term trend lines tend to stick out more than shorter-term ones; however, they can both work very well as far as using them for predicting future price movements.
However, the indicator’s primary purpose is to help you judge future price movement. It is used as a tool, not an absolute indicator of what will happen.
Knowing this information can be beneficial for traders because it hints when buyers might take control back over sellers; this causes an eventual shift in price direction (up instead of down).
To trade using this information effectively, however, you’ll need first to learn how to spot these conditions and then secondly to know when and where to place your orders.
Conditions
As always, practice makes perfect, so make sure that you paper trade or demo trade these conditions for a while before risking any actual funds.
Many traders consider oversold conditions as a potential trading opportunity because prices are more likely to reverse when reaching this level.
However, there is also the possibility that prices may continue dropping after hitting an oversold condition and result in a false breakout which can lead to heavy losses for inexperienced traders.
Relative Strength Index (RSI).
This oscillating indicator ranges between 0 and 100, with readings above 70 considered as overbought while readings below 30 are viewed as oversold.
The fact that prices drop under 50 for reaching oversold conditions signals that there is no longer enough buying pressure to push up costs and will eventually cause them to reverse.
While the prospect of a reversal may be attractive to some traders, several risks should be considered before taking any position.
Advantages
The first advantage of having oversold conditions in forex trading is that prices tend to move back quickly as soon as some market participants use support levels as entry positions.
The additional point is that traders often use oversold conditions on different timeframes as entry positions for swing and position trades.
However, not every price action trader likes using support and resistance levels on different timeframes as entry positions because they increase the risk of potential false breakouts that can lead to significant losses for intraday traders.
An additional point to consider is that when prices are oversold, they often present a buying opportunity for traders who want to establish an extended position.
When used in combination with other technical indicators, oversold conditions can provide a strong indication of when it might be a good time to buy a particular currency pair.
Risks
The first and most obvious risk is the possibility that prices may continue dropping after hitting an oversold condition.
It can result in a false breakout which leads to heavy losses for inexperienced traders who cannot accurately judge when the market has reached a bottom.
Secondly, oversold conditions can often lead to fake rallies as traders who were selling at a loss may decide to take their profits and push prices up temporarily.
These short-term rallies can be quite profitable for experienced traders, but they should not be mistaken for long-term reversals.
Lastly, oversold conditions can often trigger panic selling as traders become fearful of losing even more money. It can snowball effect as prices drop further, creating a self-fulfilling prophecy.
In conclusion
Oversold conditions can be a profitable opportunity for experienced traders who can accurately judge when the market has reached a bottom. However, several risks should be considered before taking any position.
These risks include the possibility that prices may continue dropping after hitting an oversold condition, the likelihood of fake rallies, and panic selling potential.
As with all investment decisions, it is essential to weigh the pros and cons of each situation before making a decision.