## Trading Strategies Using the Overbought Oversold Indicator

Successful trading is not about guessing but relies on systematic analysis. Experienced traders often avoid buying when prices are too high and selling when prices are too low. One way to achieve this is by using overbought oversold, an effective technical analysis tool. This article will explain how to apply this tool in real trading, along with useful examples.

## What is Overbought Oversold and Why Is It Important

Overbought oversold is an analysis that uses indicators to assess whether the price is in a deficit condition or likely to reverse, based on historical price and volume data.

When prices are sold excessively, the price drops below a fair level, called **oversold**. In this situation, selling pressure weakens, and buying interest tends to increase. The price then has a chance to rebound or rise.

Conversely, when prices are bought excessively, the price rises above normal levels, called **overbought**. In this scenario, buying momentum decreases, and selling pressure may take over. The price is likely to correct or reverse downward.

The importance of identifying overbought oversold conditions is that it helps traders avoid buying at the peak and selling at the bottom, which are common mistakes that lead to losses.

## Popular Indicators for Identifying Overbought Oversold

### RSI (Relative Strength Index)

RSI is an indicator that measures the ratio of upward price movements to downward movements over a specified period. The calculation formula is:

**RSI = 100 - (100 / (1 + RS))**

where RS = average of upward price changes over N days / average of downward price changes over N days.

The RSI value ranges from 0 to 100, clearly indicating the momentum of the price.

**Using RSI to identify Overbought Oversold:**
- When **RSI exceeds 70**, it indicates overbought conditions, meaning excessive buying, and the price may correct downward.
- When **RSI falls below 30**, it indicates oversold conditions, meaning excessive selling, and the price may rebound.

However, the 70 and 30 thresholds are standard; traders can adjust these numbers based on the asset's price behavior, such as using 75 for overbought and 35 for oversold for more stringent signals.

### Stochastic Oscillator

This indicator shows where the closing price is within the high-low range over a certain period, calculated as:

**%K = [ ( Closing Price – Lowest Low over 14 days ) / ( Highest High over 14 days – Lowest Low over 14 days ) ] × 100**

**%D = 3-day moving average of %K**

The %K value ranges from 0 to 100, similar to RSI.

**Using Stochastic to identify Overbought Oversold:**
- When **%K exceeds 80**, it indicates overbought conditions, meaning excessive buying.
- When **%K falls below 20**, it indicates oversold conditions, meaning excessive selling.

The difference between RSI and Stochastic is that RSI measures momentum based on price increases and decreases, while Stochastic compares the current price position within the analyzed range.

## When Overbought Oversold Is Not a Direct Buy/Sell Signal

It’s important to understand that overbought oversold is only an indicator, not an immediate buy or sell signal. Prices can remain overbought during strong uptrends and oversold during strong downtrends. Therefore, this tool should be used in conjunction with additional analysis.

## How to Trade with Mean Reversion

Mean Reversion is a strategy that assumes high and low prices are temporary fluctuations, and prices tend to revert to the mean. This strategy works best in uncertain markets or markets without a clear trend.

**Steps for trading Mean Reversion:**

1) Use MA200 to identify the primary trend. If the price is above MA200, it indicates an uptrend; if below, a downtrend. If the price oscillates around MA200, it indicates no clear trend (Sideway)

2) Set appropriate overbought oversold zones. For example, RSI > 90 for a strong overbought zone, and RSI < 10 for a strong oversold zone.

3) Buy when the price touches the oversold zone and exit when the price re-enters the MA5 or SMA25.

4) In an uptrend, reduce risk of shorting (short) because there’s a high chance the price will not reverse downward as expected.

**Example of USDJPY trading in a 2H range:**

Suppose USDJPY has shown a clear uptrend, reflected by multiple touches to the MA200, indicating it acts as a strong support. Using Mean Reversion in this uptrend:

- Set RSI overbought at 75 instead of 70 for more accurate buy signals.
- Set RSI oversold at 35 instead of 30 to align with the uptrend.
- In an uptrend, focus on buying at oversold points (buy) and avoid shorting (short) at overbought levels.
- Close positions when the price reaches MA25 or when a new low breaks below MA200.

The Mean Reversal strategy is most effective when the market lacks a clear trend but requires adjusting overbought oversold thresholds to suit the specific market conditions.

## How to Trade with Divergence

Divergence occurs when the indicator signals conflict with price movements. For example, while the price makes a new **Higher High**, RSI makes a **Lower High**. This situation suggests the uptrend is weakening and a reversal may occur soon.

**Steps for trading Divergence:**

1( Identify assets with a clear trend )uptrend or downtrend( and look for Divergence signals.

2) Observe whether RSI conflicts with price movements. If the price makes a Higher High but RSI makes a Lower High, it indicates Bearish Divergence, signaling weakening bullish momentum.

3) Wait for confirmation from price, such as a break below MA5 or MA25, which is a strong reversal signal.

4( Enter a short position )short) once confirmed by price, with stop-loss set at the previous high.

**Example of WTI trading in a 2H range:**

Suppose WTI )West Texas Intermediate) shows a continuous downtrend, making Lower Lows, and RSI drops below 30, indicating oversold conditions.

- Observe RSI for Higher Lows, meaning RSI does not make new lows while prices make Lower Lows.
- If RSI makes a Higher Low while prices make a Lower Low, it indicates Bullish Divergence, suggesting weakening selling pressure.
- Wait for the price to break above MA25, a strong reversal signal.
- Enter a buy when the price crosses above MA25, with a stop-loss at the previous low.

Divergence is a powerful tool for identifying trend reversals, especially when combined with overbought oversold conditions.

## Summary

Overbought oversold is a useful analysis tool that helps traders avoid buying at excessive prices and selling at undervalued levels. However, its effectiveness depends on proper application and not relying solely on it.

Using overbought oversold in conjunction with other tools such as Moving Averages, Divergence, and meaningful Price Action patterns enhances the reliability of trading systems.

Most importantly, traders must always remember that overbought oversold is only an indicator, not an immediate trading signal. Waiting for confirmation from other tools and practicing strict risk management are key to increasing trading success rates.