How to Identify Overbought and Oversold Signals | by LBank Exchange | Jun, 2023

From the LBank blog.

How to Identify Overbought and Oversold Signals

Understanding overbought and oversold signals in the crypto futures market is a crucial aspect of technical analysis that can present valuable trading prospects. As a trader, having the ability to recognize when contracts are overbought or oversold can greatly help in determining optimal entry and exit points for trades, choosing the right positions and anticipating potential trend reversals. This invaluable tool enables effective risk management and facilitates well-informed decision-making throughout the trading process. In this article, we will delve into various techniques and indicators employed in technical analysis to identify overbought and oversold signals when trading futures.

Traditionally, an overbought signal in the financial market depicts a technical indication of being overvalued. When an asset is overvalued, its real value does not align with its intrinsic value. When it comes to crypto futures, an overbought level refers to a phase where an asset’s price has been excessively bought. This often suggests that the asset is likely to experience a decline as existing buyers start liquidating their positions. The overbought level can occur abruptly when the price of the underlying asset undergoes a parabolic surge. Alternatively, it can manifest gradually over time.

Conversely, an oversold level represents the opposite of being overbought. It signifies a situation where the price of an asset has dropped significantly, leading observers to believe that it has been oversold. In fundamental analysis, this scenario is known as being undervalued. An oversold period may arise immediately after a futures contract experiences a sharp decline, typically triggered by major economic data, earnings reports, or significant news events. Similarly, an undervalued situation can persist over an extended period.

Overbought and oversold signals work by analyzing the present price of a contract in relation to its historical prices. However, these signals are definitive alarms, rather they serve as indicators of specific price patterns in the market. The signals reflect the need for heightened vigilance and closer examination of the market, along with other indicators. This is because there is a potential likelihood of an upcoming rally or a substantial sell-off.

Two widely recognized indicators for identifying overbought and oversold conditions are the relative strength index (RSI) and the stochastic oscillator. These momentum indicators are commonly displayed on a separate graph alongside the price action. They function as banded oscillators with a defined graphical range of 0 to 100. The upper and lower bands of this range represent the overbought and oversold readings, serving as the extreme levels. By observing these indicators, traders can gain insights into the potential market conditions and identify instances where prices may be reaching unsustainable levels.

The Relative Strength Index (RSI) serves as a crucial technical indicator that notifies traders about bullish or bearish oscillations in asset prices. Its calculation involves analyzing the average gains and average losses incurred by the asset over the most recent 14 periods, making it an effective momentum oscillator.

When the momentum rises and the RSI reaches 70 or above, it indicates a potential trend reversal. Traders interpret this as a strong indication against buying. At this point, the market can initiate a correction, potentially leading to losses for traders.

Conversely, RSI enables the identification of peak crypto prices, serving as a signal for traders to sell their positions at that level. This approach allows traders to capitalize on substantial returns before a price pullback occurs.

Similar to the RSI, the stochastic oscillator also operates on a scale ranging from zero to 100. An overbought status is typically indicated when the stochastic value exceeds 80, while values of 20 or lower commonly signify oversold conditions.

In other words, the stochastic oscillator compares the current price level of an asset to its range over a specified timeframe, usually 14 periods. In an upward trend, the market tends to close closer to its highs, while in a downward trend, it tends to close nearer to its lows. When prices deviate from these extremes and gravitate toward the middle of the price range, it often signifies that the momentum has diminished and a change in direction is likely.

It is important to note that when an asset gives an overbought or oversold signal, it often evokes a sense of caution while trading. While it is not guaranteed that the asset will experience immediate selling pressure upon entering the overbought zone, the likelihood of further upside potential diminishes. As a result, traders tend to opt for liquidating their positions and patiently await a healthy correction. The underlying strategy behind this approach is to secure profits and reassess the situation with a fresh perspective. However, it’s important to note that this strategy may not necessarily lead to re-entry into the same trade position.

Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.

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