Exactly…you take the dish out of the oven. Remove it from what caused its current overdone state and the sooner the better. Same deal…you do what it takes to get the engine cooled down. Immediately stop doing what caused the engine to become overheated in the first place. Given these natural reactions, it is easy to see why the initial and almost immediate reaction by many newer traders to an overbought or oversold trading scenario is to do the opposite in that case as well.
They reason that since many buy long orders moved price up and pushed the indicator into overbought territory, we must do the opposite and take a short sell position. Conversely, if many sell orders caused price to drop and the indicator to move into oversold territory we must begin to take long positions. Well…what is the proper reaction for casseroles and car engines is not necessarily the right reaction when trading.
Just because the RSI or Slow Stochastics indicator reads Overbought for example, does not mean that price action on the pair is like a tightly compressed spring that is going to immediately snap back toward the Oversold area.
Clearly a trader who went short when it first went into Overbought territory would have missed out on a great move. They also would have gotten stopped out of their short position in fairly short order. Only take entry signals from an indicator that is in the direction of the longer term trend. For example, if the trend has been strong and prolonged to the upside, it stands to reason that the indicator will be in Overbought territory since it reflects the bullish push of price action.
To take a short position at that point would be to trade against the trend and that would be introducing more risk into the trade. Trading with MACD 48 of Fast Stochastics vs Slow Stochastics.
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets. Click here to dismiss. Foundations of Technical Analysis: Classic Chart Patterns, Part I.
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