Guest Commentary: How to Identify or Dismiss an Oversold / Overbought Conditions
You often hear traders saying that a currency pair is overbought or oversold - the pair moved strongly in one direction, that it necessarily needs to pull back and correct, at least part of the move.
This could be the case, but it could be just a pause. Here are tools that will help you identify the if a correction is coming or a if you can still ride the move.
A Real Bounce
The most important thing to see is what happened immediately after the move. Let's examine a case of a sharp fall.
If the pair immediately bounced back up and managed to recover in the same session (or very shortly afterwards), the fall could be due to a lack of liquidity and the bounce is real.
This is the case of an oversold condition. It could continue correcting more or fall. It's harder to know.
Dead Cat Bounce
There's a different type of bounce, a dead cat bounce. This is when the pair doesn't move too much but rather consolidates in a very narrow range, this could be a preparation for a bigger fall.
In this case, it is not oversold. The pair couldn't recover after the move and is bouncing in a limited manner. A new session could certainly see a continuation of the move. to lower ground.
The same logic goes for the opposite situation: if the pair drops nicely after a sharp move higher, this is a real bounce. If it sticks to high ground and trades in a narrow range, more rises could follow.
Apart from looking at the price action, it's important to keep your eye open to the news. If the pair bounced after a fall and you're not certain what the situation is, listen to the news.
Bad news for the pair increase the chance of another fall. For example, if Good news or no news could point to a correction.This applies to the opposite case as well.
How do you analyze the next moves for a currency pair?
Further reading: 5 Most Predictable Currency Pairs – Q1 2012
By Yohay Elam, Forex Crunch
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