Is it a bargain, when a pair is oversold?

Explanation
</desc> How do you trade when a trading pair is oversold? We look at how to spot an oversold
forex pair and the indicators that guide the trend. </desc>.

When a forex pair is oversold, it generally implies that increased selling has pushed down the
price to an extreme level. Traders that scan these pairs will anticipate a bouncing reaction since
at times, the pairs are almost undervalued, or below the real value. At this point, the pair is
trading at or near its bottom, and the fishers here will want to buy and take advantage of the
pricing. However, most traders do not wait for the real bottom trend to form. Upon buying the
pair, it may continue to drop further, 20% to 30% until the trader quickly changes position.

Trading Implication
The implication of trading an oversold stock in most instances, is that heightened selling may
actually make the prices to bounce back and start rising. This situation contrasts an overbought
pair that implies excessive buying has pushed prices higher necessitating a pullback. Traders
should be wary and note that the decrease in price (in the case of overselling) and an increase in
price (in the case of overbuying) does not mean the price cannot keep the trend.

Prices may continue moving higher after the trader establishes overbuying or lower in the case of
an oversold pair. For instance, in a bearish market, the trading pair may continue to decline
before hitting a temporary bounce. It is vital to distinguish this bounce from a reversal since it
takes place temporarily.
Figure 1: Overselling point in EUR/NZD trading pair

In figure 1, after the stock begins to decline, it meets with four short retracements before the
actual decline continues. The pair’s price action continues until it settles below 1.6400. After this
point, prices begin the reversal from March 2021 and the uptrend takes shape. To avoid trading
at an oversold option that is yet to form, it is vital to consider indicator guidelines.

Indicators
1. Relative Strength Index (RSI)

This momentum indicator measures the strength of fresh price changes and informs the trader if
the forex pair or stock has been overbought or oversold. The RSI ranges between 0-100 where 30
is the threshold of oversold while 70 shows an overbought asset. If the trader is checking for an
oversold option, he will ensure the RSI is oscillating between 0-30, with most pairs trading at a
level of 20 before a reversal takes place.

In most cases, the buy signal is given after the RSI decreases into the oversold region (30 and
below) and then hits bullish reversal. The pair will confirm a bullish reversal when the pair opens
higher, than it closed.

Figure 2: RSI tracker on the EUR/NZD trading pair

The daily price decline continued until January 8, 2021 when it stood at 1.6852 (-1.97%) at an
RSI of 28.18. At this point, the trader may prepare to buy the pair since it is already in the
oversold point. The two-day upward retracement on January 11 and 12, 2021 was inadequate to
convince the trader that a potential upside was coming since the RSI only rose to 33.32 before it
failed to confirm the bullish reversal.

One critical factor to note is the divergence between the price trend and the RSI. In figure 2, the
price pattern coincides with the RSI all the way until the fourth retracement takes place from
February 10-15, 2021. During this period the underlying increase in price, does not correspond
with the RSI. The RSI moves horizontally and shows a declining trend until it begins the
downtrend from February 16, 2021. Since this divergence only takes place in this region, the
trader will now prepare for a short-term bullish reversal after the oversold is confirmed.

2. Volume

There is an indirect relationship between the volume movement and price action. As a textbook
rule, when volume increases, the price of the trading pair or stock will decrease. This increase is
mainly caused by an increased selling action among traders. When the volume decreases, traders
prepare themselves to sell the pair. The belief here is that there is a potential rise in price about to
take place.
Figure 3: Volume movement in the EUR/NZD

Continual increase in volume indicates that the pair is moving towards the oversold zone. As the
volume increased, price declined, until it attained to the lowest trend line. In figure 3, the lowest
region acts as the support area for the increase in prices. As a swing trader, you will wait until
the volume decrease confirms the oversold position.

The zigzag indicator in figure 3 also shows that the trendline is about to change. It follows the
decline in volume as the price closes to the oversold region.

3. Exponential Moving Average (EMA)

Figure 4: EMA 20-day close in the EUR/NZD trading pair

The 20-day exponential moving average (EMA) as used in this trading chart shows the
relationship between the price and volume trends in the short and long-term. Other than the
EMA, the trader can also use the simple moving average (SMA) to indicate price turning points
and trend continuations.

In figure 4, the EMA position shows a bump as it nears February 25, 2021. This bump indicates
a trend change from a downtrend to an uptrend. The trading pair moves towards the oversold
position thereby giving a buy signal.
Conclusion
A trading pair is considered a bargain when it reaches the oversold condition. However, it is vital
to establish the correct oversold position to avoid pre-mature buying. The trader should use
various indicators to establish whether the forex pair has attained the oversold status. When the
RSI hits 30 and below, then the trader should prepare to sell. Wait until the RSI hits the lowest
point before you sell. Other aspects such as volume increases and the moving averages are
essential in estimating the price change.