The notion of overbought or oversold is extremely common when trading currency markets or binary options based on a currency pair as the financial instrument.
It is important to know that all the indicators, and especially the oscillators, are meant to show levels in which one should buy or sell. Some of them, (the levels) are extreme, and that makes the overbought or the oversold territory.
How to Trade Oversold/Overbought Levels
Of course, when trading binary options and price find itself in overbought areas, we should engage into buying put options as we should look for lower values to come. The opposite is true as well, as when price is in oversold areas we should buy call options as we’re hunting higher values.
There is one catch though and this is the main theme of this article. Price may stay in extreme areas for quite some time and while being there it means margin calls are triggered on accounts that are trying to fade the move.
Also important is the fact that each and every oscillator is showing overbought and oversold areas and this is why is indicated to have only a couple of indicators to watch for your technical analysis instead of looking at too many as they are showing exactly the same thing. Therefore, either looking at these levels with the RSI, or CCI, or any other oscillator will give you nothing but the same information.
Trading at Extreme Levels
Trading is not a straight line, but being able to play with these extreme levels and put the expiration date according to the time frame the overbought and oversold appears, makes the difference between a successful trader and one that still struggles.
In trading in general and in trading binary options in particular, overbought and oversold levels are the ones that are giving the entry price, or the striking price in our case. It is not like every time market is in overbought or oversold level the striking price is the best ever. In this case, everyone will win. The thing is to clearly make a distinction between situation and filter signals based on a predetermined system.
Breaks into Bullish/Bearish Market
Before doing that, it should be mentioned what is making an overbought and/or oversold level in order for the terminology to be fully understood. When the market is in a rising trend or in an impulsive or motive wave according to the Elliott Waves Theory, breaking some technical levels in an oscillator makes the break into a bullish market.
After being in a bullish market and the move is not stopping, but advancing some more, it is said that market is moving into one direction and one direction only. This attracts sellers or put options buyers as the longer the market stays in that area, the more “overbought” the levels are coming and more sellers are coming to join the party.
In the case of oscillators, this is happening when the oscillator travels and stays in the upper side of the territory it travels. For example, in the case of the RSI (Relative Strength Index), a break above the 40-50 level is considered a bullish break while a move above 70 is already considered overbought. If price breaks even the 80 level and stays above 70 then sellers will try to step. This is overbought territory.
Staying Liquid Longer than Market Can Stay Irrational
However, market may stay irrational and in an overbought/oversold stance more than a trader can stay solvent so careful with the expiration date for the option that is traded. That being the case, look at the time frame the oscillator is being plotted as the bigger the time frame, the more important the overbought/oversold interpretation.
Oversold/Overbought in Elliott Wave Theory
Another example comes with Elliott Waves Theory and I will use here the concept to give you a situation for an oversold level. According to Elliott, an impulsive move needs to have an extended wave and this means market should travel more than 161.8% when compared with the length of the first wave as the third wave is usually the one that is extended.
That being said, traders are taking a Fibonacci expansion tool and measure the length of the first wave to find out the extension and that outcome is projected by the time the second wave is ending. The outcome is the target.
Until that target comes, no one is looking at the market being oversold, but after it, bulls will join the party and call options are being bought. However, even in this case it is tricky and risky to buy call options just like that as the 161.8% level is only the minimum requirement for a wave to be extended.
What it is to be done is to filter in both situations, oscillators and Elliott, the decision to trade an option with something else, like a divergence or something. The bigger the time frame, the safer the option.