Overbought / Oversold Mindset Is Useless With FX

I’m used to hearing the words “Overbought” and “Oversold” thrown around in equity trading rooms and within casual conversations among traders at the local bars/lounges. The terms are also used quite a bit by various television personalities when sharing their opinions about certain stocks. And though it might be possible to roughly determine when an issue is momentarily “overbought” or “oversold” with equities, using the Level II screen as a tool to better gauge buying and selling pressure, it is basically a guess when trading the FX market.

This is because there is no one order book in the FX market (there is no central exchange for FX trades) as there is with equities, futures, etc., – that means there is no one official source of all global trading volume or trades done like there is with other markets. Every market maker has their own volume numbers based on the deals they’re doing directly with other market makers or on behalf of their retail clients (see post, “Behind the Closed Doors of FX Market Makers“). Because this information is fragmented, you have no real way of knowing if the FX pair you’re trading is starting to be overbought/oversold as you might with traditional equity trading.

Retail FX market makers offering platforms that show multiple price levels (appearing like Level II screens in equities) are not true Level II. First, the levels don’t show you who the market makers / banks are behind each price quote/size – it’s anonymous. So trying to read which “players” are buying/selling for the day in a particular FX pair is not possible. Second, their levels show the prices/liquidity being made available via their platform only – it’s not showing total global liquidity as one would find with equity Level II screens. So if you think trading on this type of FX platform will give you the same kind of edge that equity traders have, think again. At best, it will allow you to be able to tell how deep the liquidity goes relative to the pricing available so that you can best anticipate how likely your large order (usually orders bigger than 5 mil.) will get filled.

Anyway, the point is you’ll be a better trader avoiding an overbought/oversold mindset. Just stay neutral, read the tape, and let the price tell you when it might be done  rising/falling. You won’t be right 100% of the time but at least you won’t be leaving money on the table by selling or covering a position too early just because you think a pair couldn’t possibly go further (ie. overbought or oversold).

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