TECHNICAL ANALYSIS
FX
Understanding true concepts of overbought and oversold
The term overbought and oversold is heard on the wires and commentaries and is an integral part of any trader’s armoury, but it is a common theme that when I question traders or present at seminars, the common most tools that are used to quantify this are the Slow Stochastic and RSI. This re-enforces a common theme in technical analysis, in that the long established m a n t r a s continue
to
feed through as each new set of traders enter the markets. The common philosophy is that once value goes beyond 80 and 20 for the Stochastic and 70 and 30 for the RSI, the market is overbought or oversold.
H o w e v e r ,
when these concepts are actually put to the test the laziness and inaccuracy of this concept highlights how, not only can this cause problems by exiting good trend following trades too early, it can also
encourage the ruinous strategy of trying to catch tops and bottoms with such a theory. If the common perceptions of what constitutes divergence are also applied the results can be even more damaging. The theory here states that negative divergence is being created if price makes new highs for the trend but the indicator of choice fails to do so and subsequently turns down (a failure swing ). The reality is that all but the most explosive of trends that move
into
blow off tops or capitulation b o t t o m s , n o r m a l l y diverge, and in many cases can continue to do so throughout much of the trend.
The inherent flaw when
thought about is somewhat obvious. The indicators of choice have limits of scale and the market in theory can move anywhere and often can do it very quickly. This flaw becomes apparent when looking
FX TRADER MAGAZINE July - September 2010 7
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