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Forex traders always seek to get the best entry point for a trade, and often one of the better tools is technical analysis. One of those tools is looking at historical price action and identifying key areas where prices have reversed course in the past.
Overbought conditions in forex refer to a situation where a currency has appreciated in price to a level that is higher than what is considered reasonable or fair.
The “overbought territory” indicator looks to identify these areas and can be used as a warning sign for future trends reversing direction or as a perfect chance to enter into a long position, which would be signalling that an uptrend will continue higher.
This can often lead to a reversal in the price trend as investors take profits and sell the asset. It’s important to note that overbought conditions are not necessarily bad news for a currency. In fact, there are times when an overbought currency will continue to rise in price.
An overbought reading suggests that there are more buyers than sellers in the market at that time, meaning that if this area holds as resistance or supply, then it should see selling pressure push prices lower. However, if there is no selling pressure, the uptrend will likely continue, and traders can look for buying opportunities.
It’s generally advisable to avoid buying into an overbought currency, especially if you’re aiming to hold the position for an extended period of time. One way to gauge whether a currency is overbought is to look at its Relative Strength Index (RSI). You can then use this information to determine whether or not the currency may experience a reversal in price at some point.
Let’s look at an example of how to do this using EUR/USD to explain the concept further.
Overbought conditions in forex – The RSI
The Relative Strength Index is typically given as a number between 0 and 100, with anything over 70 considered overbought, and under 30 considered oversold. When using this indicator it’s important to remember that these are broad guidelines only, rather than hard rules. It should also be noted that the RSI has its limitations, especially when used on short-term timeframes.
There are many other techniques that you could employ for analysing charts, and the RSI should only be used as one tool in your trading arsenal.
In the EUR/USD chart below, we can see that the currency pair has been in an uptrend for some time, with prices reaching a high of 1.1827 on 15th December 2016.
The RSI was also trending upwards, reaching a high of 82.14 on the same day. This indicates that EUR/USD was overbought at this point and could be due for a reversal in price.
Pros and cons of overbought conditions in forex
overbought conditions can lead to a reversal in price trend as investors take profits and sell the asset. However, this isn’t always the case and an overbought currency may continue to rise in price.
When using the RSI indicator it’s important to remember that these are broad guidelines only, rather than hard rules. In addition, there are other techniques that can be used for analysing charts which should be considered when making trading decisions.
In this case, our hypothesis was incorrect as the price continued to move upwards. However, it’s important to note that there are times when even an overbought currency will continue to rise instead of reversing direction.
In these cases, you should proceed with caution and be prepared for wide fluctuations in prices until a trend reversal occurs.
This is especially true if you have a short-term trading timeframe where your strategies may be more vulnerable to changes in momentum.
Conclusion
If you’re interested in learning more about how you can use technical analysis then there are many resources online that can help get you started.
One resource we’d recommend checking out is the Forex Trading Course From Investoo.com. It’s a comprehensive guide that covers all the basics of forex trading, and is perfect for beginners.
