Indicators 3

Indicator No. 3: An Overbought/Oversold Tool

After opting to follow the direction of the major trend, a trader must decide whether he or she is more comfortable jumping in as soon as a clear trend is established or after a pullback occurs. In other words, if the trend is determined to be bullish, the choice becomes whether to buy into strength or buy into weakness. If you decide to get in as quickly as possible, you can consider entering a trade as soon as an uptrend or downtrend is confirmed. On the other hand, you could wait for a pullback within the larger overall primary trend in the hope that this offers a lower risk opportunity. For this, a trader will rely on an overbought/oversoldindicator.

There are many indicators that can fit this bill. However, one that is useful from a trading standpoint is the three-day relative strength index, or three-day RSI for short. This indicator calculates the cumulative sum of up days and down days over the window period and calculates a value that can range from zero to 100. If all of the price action is to the upside, the indicator will approach 100; if all of the price action is to the downside, then the indicator will approach zero. A reading of 50 is considered neutral. (More on the RSI can be found in "Relative Strength Index Helps Make the Right Decisions.")

Figure 5 displays the three-day RSI for the euro/yen cross. Generally speaking, a trader looking to enter on pullbacks would consider going long if the 50-day moving average is above the 200-day and the three-day RSI drops below a certain trigger level, such as 20, which would indicate an oversold position. Conversely, the trader might consider entering a short position if the 50-day is below the 200-day and the three-day RSI rises above a certain level, such as 80, which would indicate an overbought position. Different traders may prefer using different trigger levels.