As a binary options trader you will regularly encounter the terms oversold and overbought. Knowing how to trade overbought and oversold markets can take your trading to the next level and greatly benefit your success.
What are overbought and oversold markets?
The terms overbought and oversold describe market conditions that make an impending turnaround highly probable. These conditions arise when the market has moved into one direction for a longer period of time.
For the market to rise, more people have to be willing to buy than to sell. That means, there has to be a large number of people looking to invest in an asset that currently are not invested. As more and more of these people invest, the market rises while the number of people willing to invest decreases.
After a while, the number of people wanting to invest has decreased so far that it has become smaller than the number of people willing to sell. This will cause the market to turn around. All upwards momentum is gone. The market has to go through a consolidation period to generate new momentum before it can start to rise again.
The same process happens during a downwards market movement: After the market has fallen for a while, the number of people willing to sell their asset will become too small to generate enough momentum to keep the movement alive. The movement will weaken, and, eventually, the market will turn around.
What happens in overbought and oversold areas?
As we can conclude from these examples, there is a relationship between the distance of a movement and the likeliness of the market turning around. To quantify this relationship, we need to compare the distance the current movement has moved to some quantifiable value.
The most simple version of doing this is to compare the number of rising and falling candlesticks over the last periods. A simple version of this theory claims that the market in highly unlikely to rise four days in a row. If the market has risen the last three days, you know to expect a falling market today.
A more sophisticated possibility to estimate whether an asset is overbought or oversold is using technical indicators such as the Money Flow Index (MFI). The money flow index does not simply compare the number of rising and falling periods, it also factors the volume and the bandwidth of each period into the calculation.
First, the MFI calculates the typical price for each period as the average of high, low, and close of the period. It then multiplies the typical price with the volume of the period. Thirdly, it adds the result of all periods with rising prices up and divides them by the sum of all periods with falling prices. The result is called the money ratio. Finally, the MFI converts the money ratio into a percentage and forms the MFI (MFI = 100 – (100 / (1 + money ratio))).
When the MFI reaches a value of over 80, a lot of money went into the stock over the last periods and the asset is considered overbought. When the MFI reaches a value of under 20, a lot of money went out of the stock over the last periods and the asset is considered oversold. In both cases, it is questionable whether there is a lot of money left to keep the current movement alive.
The MFI is not the only indicator that uses overbought and oversold areas. Many other oscillators use overbought and oversold areas. The difference in indicators is how they generate their values.
How to trade overbought and oversold areas
As a binary options trader it is important to understand that an overbought or oversold value does not necessarily have to mean that the market will definitely turn around soon. In a trend, the market can stay in oversold / overbought areas for a long time and still keep moving in its main direction.
Swing traders, which invest in options with shorter expiration times than trend followers, can use oversold / overbought indications as a first sign that the current movement might be weakening and should use other indicators to confirm that prediction and find the ideal time to enter the market.
Trend followers, on the other hand, should not be concerned when the market reaches an overbought or oversold value. Instead, they should look out for situations in which the market creates a new extreme without the indicator creating a new extreme in the overbought / oversold area. This development usually indicate a trend in deep trouble.