When you trade in binary options you will come across the words “overbought” and “oversold” with considerable frequency. Knowing what they tell you about the markets, and how your trading should be adapted to markets that are oversold and overbought, respectively, can improve your performance greatly.
When the market conditions can be termed either as oversold or overbought, a future turnaround in likely to occur. Such conditions appear when the market has been going in one direction for a considerable time period.
In order for the market to rise, a greater number of traders must be looking to buy than to sell. Consequently, we need to see more traders seeking to invest in an asset than have so far invested. As the number of traders who have not yet bought the asset in question shrinks, the price increases. At the same time the number of potential investors goes down.
At some point, the amount of potential investors who wants to buy the asset has shrunk so much that it is smaller than the amount of traders who want to sell. This will result in a turnaround of them market direction. The momentum driving it upwards has expired, and a consolidation period will ensue. Only when new momentum has been gathered, can the price begin to move upwards again.
An identical process in reverse can be observed when the market is moving downwards. The number of traders who want to sell the asset will decrease as the price drops. In the end the number will become insufficient to drive the price further down. As a result, the movement will seize. In time, the market will consolidate and then move in the opposite direction.
One thing we can learn from the examples we have looked at, is that there is a relationship between how far a market has moved and the likelihood of the market changing direction. In order to quantify this phenomenon, we have to compare the distance the ongoing movement has travelled to a value we can quantify.
The simplest way to do this, is to compare the amount of falling and rising candlesticks during the most recent periods. A basic version of this theory holds it as true that it is highly improbable that any market will see sustained growth over four consecutive days. Accordingly, you can conclude that if the market has been in an upwards movement for three days, a downwards turn is imminent the following day.
You can also use a more advanced approach such as employing a technical indicator, for example the Money Flow Index (MFI), in order to estimate if the market is oversold or overbought. The MFI does more than just compare the amount of falling and rising periods. In addition, it takes the bandwidth and the volume of each period into consideration.
The MFI first estimates the average of the high, low and closing price of the period, and defines this as the period’s typical price. Then it multiplies this typical price with the period’s trading volume. Then, the MFI adds the results for the rising periods and divides them by the sum of the periods that had experienced downwards movement. The final product is the Money Ratio. Lastly, the MFI turns the Money Ratio into a percent and creates the MFI. We can show the MFI in the form of the following equation: MFI = 100 – (100 / (1 + money ratio)).
Once the MFI exceeds a value of 80, you can conclude that a lot investments have gone into the asset during the most recent periods. In other words: the asset is overbought. On the other hand, once the MFI dips below 20, a lot of investments have been flowing out of the asset recently. It is oversold. Both scenarios ask the question: is there enough investment remaining in order to the ongoing movement continued momentum?
There are other indicators that can be used to identify markets that are overbought or oversold. Among them are a number of other oscillators. They differ in how their values are generated.
One thing that it is very important to realize is that an oversold or overbought value is no guarantee that an imminent change in market direction is due. It can happen that a trend stays in an overbought or oversold area for a considerable period of time whilst maintaining its direction.
As a consequence, Trend followers should not trade on the basis of the market being oversold or overbought. Rather, they are well advised to search for conditions where the market reaches a new extreme without a new extreme in the oversold or overbought area being created by the indicator. Should this occur, it is an indication that the trend is weakening dramatically.
Swing traders who invest in options with shorter expiry times than trend followers do, can use signs that the market is oversold or overbought as an indication that the ongoing movement could be losing momentum. They should confirm this observation with the use of other indicators in order to determine the optimal moment to make the appropriate binary options trade.