Monday, November 20, 2006

 
Trading Education Tutorial

Overbought / Oversold / Overload

Analysts love to show off by proclaiming that the markets have become overbought or oversold. Unfortunately, few of us seem to understand what these terms really mean or what we should do when these moments of truth arise.

Should we run for the hills because a market is overbought, or perhaps load up the boat because it's oversold? And how do we know when one of our trades might fall prey to one of these extreme conditions?

The best way to understand overbought or oversold markets is to study the nature of supply and demand. At any given moment, a finite pool of buyers and sellers is available to take action on a particular stock. The trading activity of this crowd usually stays within fairly narrow boundaries.

But imbalances develop over time and force one side to pull the trigger, sometimes prematurely. This "uses up" that side of the market and awakens price mechanics that favor the other side.
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