Trading with Overbought/Oversold indicator levels is a common way in which to identify possible trading opportunities. It can be a very reliable method of identify changes in both short and longer term trends.
In my previous article where I looked at a simple binary options moving average strategy that looked to capture trending moves in price.
this second strategy article I want to look at a simple technique that can be used to profit from movements within the trend.
We have already covered the fact that trends in asset prices are a strong phenomenon. However they should not be assumed to be linear. This means that within a trend there will always be periods where the price action takes a rest and consolidates for its long term direction. At these times the price of an asset is often referred to as being ‘overbought’ or ‘oversold’. Essentially this means that the market has temporarily overextended itself.
There are many ways in which extreme points in the market can be identified. Two of the most commonly used technical indicators which are used to identify these times are the Relative Strength Index (RSI) and Stochastic Oscillator.
Both of these indicators measure the ‘rate of price’ change. When an asset price moves beyond the average rate of change, the oscillator will move into either overbought or oversold territory. For the RSI indicator this is normally assumed to be when the level posts above 70 (overbought) or below 30 (oversold). When using the Stochastic oscillator the most common levels used are 80 and 20 respectively.
The Overbought/ Oversold Markets Binary Trading Strategy
This strategy for trading on binary options works well with Forex options, particularly when used with hourly contracts. You can of course apply this methodology to other markets and time periods if you wish.
When trading with one hour binary contracts if is best to follow the price movement on a five minute trading chart.
To set yourself up to trade this method you will need the following:
- A chart of your asset set to a 5 minute time-frame
- To know the directional trend of the market (see previous article)
- Stochastic Oscillator configured on your chart
- Binary trading account open and set to trade hourly contracts
The Stochastic Oscillator can be configured with a number of different settings. However I tend to stick with the most common (8,3,3) in conjunction with the simple moving average.
The Strategy Theory
The chart above shows the EUR/USD with the oscillator plotted. You can see that the lines from the indicator oscillate up and down as the price action moves on the chart. With this strategy we are only interested in the times when the indicator has registered either above 80 or below 20. These signify that the price gain in the asset has entered an extreme oversold/overbought reading.
The strategy is looking to capture the temporary unwinding of this extreme rallies against the dominant daily trend. If an extreme reading is reached, then a contract is purchased in the direction of the dominant trend to run until the next hourly expiry.
The method makes of use of the basic Call and Put binary option contract.
The Entry Signal
The signal for a trade entry is when BOTH lines on the oscillator have moved back OUT from the extreme reading. At this point you open a contract in the direction the daily market trend.
Let’s take a look at the following real examples to help clarify the signal entry.
The EUR/USD was in a downtrend over the previous trading days. Therefore we look to buy any intraday ‘rallies’. These are signalled when the osciallator shows readings above 80.
Example 1 - At around 07:40 the price moves out of the overbought reading with both lines of the oscillator crossing back below 80. At this point a PUT contract is placed for the nearest hourly contract (08:00).
Example 2 - At around 08:50 the chart reading again shows the pair overbought. A PUT contract is again placed for the nearest hourly expiry at 09:00.
Both of these examples saw PUT contracts placed. However the strategy works exactly the same in the reverse. If the daily trend of the asset is higher then the extreme reading used would be 20 (oversold). In this instance a CALL contract would be placed to close at the nearest hourly expiry.
The exact number of trading opportunities and the performance you get will vary. While I enjoyed an 85% strike rate for the day when writing up this article (6 wins, 1 loss) you should not expect this to happen all of the time. Over the longer term I expect to see a strike rate of around 70% (7 winners, 3 losers). This will net you a very good return over the long run.
Things To Consider
The strategy as presented is designed to be simple. You could however refine if further. Adding additional indicators or confirmations to each signal may help to improve the results you get.
It is however important that you only trade overbought and oversold levels when they occur against the dominant trend. If you don’t then you are likely to become unstuck.
As ever it is worth keeping an eye open for any big upcoming big news. These could derail the daily trend and cause a sudden shift in sentiment. Daily markets can quickly change and the price action reverse if the fundamental outlook suddenly changes.
Finally as ever, put in place a good risk control strategy so that you don’t overexpose yourself when trading. I tend to use around 5% of my capital set aside for this strategy for each contract placed.