Erik Weijers, 6 months ago
If an asset, for example, a cryptocurrency, is overbought, it is too expensive. If it's oversold, you can buy it at a discount. That's the shortest way of explaining it. Determining this can be a matter of common sense, but there are also technical indicators that help with this.
In crypto, perhaps more than in any market, sentiment rules. A speculative frenzy can drive prices up to unsustainable levels. A crash will follow. On the other hand, in bear markets, the mood can get exceptionally gloomy. Nobody wants to touch crypto with a ten-foot pole. That's a time when it is oversold.
On the charts, what is the rough sign that an asset is overbought? It's when the price has been moving higher and higher without a correction along the way (see the below Ethereum chart of spring 2021). What is a sign that an asset is oversold? When the price has been going down in a rather straight line, without a correction to the upside.
Why the straight line? Coming back to the highly temperamental aspect of crypto (or other markets, but crypto in particular), the straight line is a visual indication of the rigid emotional state traders are in. If everyone is euphoric, you get caught up, and you can't bring yourself to sell (or vice versa in a depressed mode). The normal 'noisy' chart patterns disappear for a while. But this state can't last and has to snap back to reality.
Of course, the 'quants' don't rely just on gazing at a chart and drawing intuitive conclusions on how oversold or overbought something is. Metrics have been fabricated that can quantify these levels. The two main ones are the RSI and the stochastic oscillator.
Both give an objective reading and help prevent you from jumping into a trade that probably has just exhausted itself in the current leg down or up. In other words, by understanding the level of overbought-ness or oversold-ness, you can time your entry and exit points better.
Of course, there will never be a perfectly timed signal. Even if the indicator signals 'oversold', that doesn't mean the price can't go lower from there, and the indicator can get even more oversold.
The Relative Strength Index (RSI): measures the speed of price change and quantifies this on a scale of 0 to 100, where 0 means giga oversold and 100 hyper overbought. As a rule of thumb, you don't want to buy whenever the RSI is at above the top of the range (a score of 70) - and you don't want to sell when it is near of below 30. Simple, ay? Except it won't work exactly like clockwork. It's just an indicator, after all.
The stochastic oscillator is like the RSI indicator, but it uses the closing prices as its inputs and averages those out. It's a smoother line than the RSI (this depends, by the way, on the settings that you pick). The stochastic oscillator has a reading from 0 to 100. The overbought and oversold levels differ from the RSI: 80 and 20 versus 70 and 30, but the principle is the same.
The relative strength index (RSI) and stochastic oscillator are both price momentum oscillators. They have slightly different underlying methods. Whereas RSI measures the speed of price movements, the stochastic oscillator assumes that closing prices should move in the direction of the current trend. As a rule of thumb, the RSI is more useful during trending markets and the stochastic oscillator is more in sideways or range-bound markets.
Divergences between price and the indicator for oversold/bought are important clues about possible price directions. A divergence means that the price movement of the coin has a different direction than the technical indicator you use. If the price is still going down, but the indicator is going up, this signals a reversal. Does it mean the price will rip up? Not necessarily, but it suggests that the momentum of the move down is ready for a pause or reversal.
Different crypto traders have different trading strategies, for example, depending on their time horizons. The nice thing about the oversold/overbought indicators we mentioned is that they can be accommodated to different timeframes. You'll hear analysts say: 'a bullish divergence on the weekly RSI' or a 'bearish divergence on the 4-hour RSI'.
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