If you’re new to trading and markets you will often hear two terms that sound intuitive, but you may not fully understand; overbought and oversold. From investopedia.com: “Overbought is often a term used in technical analysis to describe a situation in which the price of a security has risen to such a degree – usually on high volume – that an oscillator has reached its upper bounds. Oversold is a condition in which the price of an underlying asset has fallen sharply to a level below where its true value resides. This condition is usually a result of market overreaction or panic selling and is generally considered short term in nature. When an asset has been oversold, the price is expected to rebound in an event referred to as a price bounce.”
When you hear these terms, people are often relying on a set of technical tools called the “Stochastic Oscillators” to identify these conditions. Stochastics were developed by George Lane in the late ’50’s to measure the speed of price move during trends and try to identify when the momentum of a trend was slowing. The idea behind the stochastic oscillator is that in an uptrend, price should close near its high price and in a down trend, price should close near it’s lows. Stochastics track the location of the closing price of whatever security, commodity or future you are looking at, in relation to the high and low range of the price over a period of time. As the closing price moves further away from it’s highs or lows, then the trend is becoming overbought or oversold. Lane himself has said that the stochastic oscillator does not track price or volume, but the speed or the momentum of price. The thought being that the speed or momentum of a move slows before the actual trend changes. The oscillator is set with a range of 0-100 and overbought or oversold are measured by two horizontal lines called K and D lines. Note on the 15-chart below, those lines are set at 20 and 80 which is the default setting for most charting platforms. Each time the stochastics reached 80, there was a reversal and a fall in price. Each time that price reached 20, except for once, there was a reversal and a rally in price.
Stochastics may not be the best trade entry tool. There is an old market cliché that says “Markets can stay overbought and oversold longer than you can stay solvent” which has proven to be true over time. However, since Nadex Binary options and spreads give you the opportunity to exit trades prior to expiration (a huge advantage), You may want to research and include stochastic oscillators into you plan as one of the ways you decide whether to capture current profits or wait until your trade expires to capture the full profit available to you.