Maximizing the Potential of Overbought & Oversold

The Overbought and Oversold strategy remains one of the most popular and frequently used approaches in forex trading. This is largely due to its simplicity and the minimal number of rules involved.

For traders utilizing this strategy, identifying overbought and oversold levels is as simple as employing momentum indicators like stochastic, MACD, or RSI. For example, with the stochastic indicator, overbought is typically considered within the 80 zone, while oversold is below 20.

It's crucial to remember that these levels are not guarantees of impending price reversals. Rather, they represent potential zones where the probability of a trend reversal is relatively high. Many traders incorporate additional confirmation tools to assess the likelihood of a reversal within these areas.

Despite its apparent ease of use, the Overbought and Oversold strategy doesn't enjoy continuous usage by all traders. Many who initially adopt it eventually shift to other methods. This primarily stems from concerns about its effectiveness and potential for incurring losses.

Is Overbought and Oversold Inherently Flawed?

Declaring any trading strategy "bad" or "good" in forex requires personal testing through backtesting. As I've advocated in previous articles, backtesting empowers you to assess the efficacy of your chosen strategy.

Remember, any trading strategy you encounter is essentially a theory. Evaluating its validity necessitates personal testing, as published strategies rarely feature comprehensive statistical data regarding their performance. This leaves traders with limited understanding of a strategy's true potential.

Unlike scientific theories meticulously tested and documented in peer-reviewed journals, trading strategies lack such established validation processes. While scientists can readily accept published theories without independent verification, forex traders must perform their own due diligence.

However, I believe the Overbought and Oversold strategy holds potential. Its continued survival in the face of time suggests viability. If it were consistently ineffective, it would likely have fallen by the wayside long ago. The continued prevalence of the terms "overbought" and "oversold" highlights its enduring usage.

How to Improve the Efficiency of Overbought and Oversold Strategies

Even though I don't know whether the overbought and oversold strategy has good or bad performance, I have a decent understanding of it based on my past experience. I used it as a complement to my main strategy, but eventually stopped because it conflicted with my primary approach. Combining them generated confusing signals that made decision-making difficult.

The overbought and oversold strategy is a trend reversal strategy. It encourages traders to open positions opposite to market sentiment. The advantage is potentially better entry prices by anticipating trend changes. However, it's risky, as prices might not reverse and continue moving in the same direction. This can lead to significant losses due to the wider price ranges and strong momentum characteristic of trending markets. Traders might not be able to react quickly enough to close their positions, resulting in substantial losses.

To maximize the potential of this strategy, understanding suitable market conditions is crucial. Markets exhibit two main price movements: trending and ranging. Trending markets favor trend-following strategies, while ranging markets suit trend reversal approaches.

Since overbought and oversold are reversal strategies, their performance peaks in ranging/sideways markets. Observe the following image:

EURJPY time frame H4, period 31 July 2020 - 12 September 2020

The image demonstrates the high accuracy of the stochastic indicator in predicting overbought and oversold levels during sideways movement. Hypothetical trading during this period would have yielded 10 profitable transactions and 5 losses out of 15 opportunities.

Now, take a look at this second image:

EURJPY time frame H4, period 1 April 2021 - 2 June 2021

This image highlights the poor accuracy of the stochastic indicator in determining overbought and oversold levels in a trending market. The indicator generates 9 signals, only two of which are correct.

Comparing these examples reveals that the overbought and oversold strategy is significantly more efficient in ranging/sideways markets than in trending markets.

This principle applies not only to this strategy but also to all trend reversal strategies, including candlestick reversal patterns, chart pattern reversals, support and resistance rejections, divergences, and so on. So, if you use a trend reversal strategy, consider its efficiency solely within ranging market conditions.

#OPINIONLEADER#