Overbought and Oversold Areas in Ranging Markets
A ranging market is defined as a consolidation area during which time price is not really going anywhere. Ranges differ from currency pair to currency pair, as for one pair a classical range may be twenty or thirty pips, while on some other pairs it can mean a hundred pips. A range depends also on the time frame used to identify it. If the range is forming on the monthly or weekly chart, then it is only normal for the range to be bigger in the number of pips market travels, when compared with a range that forms on the hourly chart for example. Take a contracting triangle for example. By definition, this is a ranging pattern, but such a triangle is always having a smaller range on lower time frames than on the bigger ones. Why are ranging markets so important and why is one interested in them? The answer is pretty simple and comes from the fact that the Forex market is ranging most of the times. This may come as a surprise as this market is best known as a market where prices of currency pairs are traveling a lot. In reality, most of the times prices are ranging, only that these ranges are forming on different time frames.
Defining an Overbought and Oversold Market
In order to define such an area, a trader should calibrate his/her expectations when compared with the trading style involved. Therefore, if the trading style is based on an investing approach, then this article is not for those traders. When investing, the period of time taken into account is fairly big and a few hours, days, or even weeks of consolidation doesn’t change the trader’s perspective and analysis. Therefore, overbought or oversold areas are not interesting for these traders. However, if the time perspective is shorter, then these areas are proving to be quite useful to swing and scalp traders. One thing should be mentioned though before we move forward: markets can stay in an overbought or oversold area longer than a trader can stay solvent. This means that there are only specific moments of time when it is advisable to trade these areas. Otherwise, the risk is to end up chasing a move that will never come and in the end, this will be seen in the trading account.
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Using Oscillators to Find Overbought and Oversold Areas in Ranging Markets
All oscillators offered are showing the same thing: overbought and oversold levels. No matter the one you choose, be it the Relative Strength Index (RSI), the Commodity Channel Index (CCI), DeMarker, or any other oscillator, the standard interpretation is the same: traders should sell in overbought areas and buy in oversold areas. If this is correct, why more than ninety percent of traders are still losing money? The answer comes from traders now knowing when to use these overbought and oversold levels. Providing a range market or a ranging environment is expected, the only way to find these areas are by using oscillators. Any oscillator from the ones listed above can show overbought and oversold levels. Based on what we discussed so far, it seems that the key is to know how to find a ranging market before selling in overbought and buying in oversold areas. Without this, it is virtually too risky to trade such levels.
When to Expect Ranging Conditions
By far, the most common place to look for a ranging market is to wait for the Asian session to start. Asian sessions are spending most of the time in consolidation as they are following the daily rollover and the main financial centers in the world, London and New York, are closed. Having said that, it doesn’t mean that in Asia there are not enough traders to move the market. Only that Forex trading is not referring to retail traders as they represent quite a small proportion of the overall foreign exchange markets. Big institutions, banks, investment houses, clearing houses, etc., are active during the London and New York session and these are the times market moves. What these institutions are doing is setting up a trading desk in Asia, but this is hardly a trading desk for new strategies to be deployed. It is a trading desk for being prepared to react if something is happening in the Asian session. Bank of Japan (BOJ) and Reserve Bank of Australia (RBA) are having their monetary policies in the Asian session and price is moving aggressively surrounding those releases. Lately, People’s Bank of China (PBOC) is acting more and more in correlation with other central banks so Chinese news matter as well. Based on the above, the idea is to use an oscillator on the lower time frames (ideally the five-minutes chart), during the Asian session, for buying oversold and selling overbought levels. However, not all Asian sessions are recommended, as the ones when BOJ, RBA or PBOC are expected to hit the wires with some important news should be avoided.
Swing Trading with Overbought and Oversold Areas
Swing trading can be used as well when trading overbought and oversold levels in ranging markets. For this, one should identify a longer period of time during which price may range. The classical example here comes from the Non-Farm Payrolls (NFP) week. Such a week is most of the times a ranging one, in the sense that the NFP is always being released on the first Friday of each trading month. Therefore, in such a week, one should expect ranges, so oscillators should be applied on currency charts. However, when compared with the previous case, one can use these oscillators on the hourly and even the four hours charts in order to find out fake moves into overbought and oversold areas. Using this example, if the market is traveling on a Tuesday of the NFP week, chances are that break is a fake one and until the NFP prices will get back into the initial range. This is when overbought and oversold levels are really useful as they will help trades profit from short to medium-term swings.
Other educational materials
- Bollinger Bands – Profit from One of the Best Trend Indicators
- Trading with the Cloud – Use Ichimoku Cloud to Spot Reversals
- Trading Forex with the Kinjun/Tenkan Cross
- What is a Currency Pair?
- Majors and Crosses – How to Trade Them?
- Leverage and Margin Requirements
Recommended further readings
- The econometrics of financial markets (Vol. 2, pp. 149-180) Campbell, J. Y., Lo, A. W. C., & MacKinlay, A. C. (1997). . Princeton, NJ: princeton University press.
- Forecasting volatility in financial markets: A review. Poon, S.H. and Granger, C.W., 2003. Journal of economic literature, 41(2), pp.478-539.