The Effectiveness of the Signal of Overbought and Oversold

Oscillators are listed among the most popular indicators among traders. The reason for their attractiveness is the ease of identification of trading signals that they offer.

Traditionally marked out are several types of signals that are derived from the following oscillators:

• divergence;
• the crossover of moving averages with various parameters;
• the exit of the signal line of an oscillator from the overbought/oversold zones.

In our study, we suggest examining the last of the listed types of oscillator signals: «overbought and oversold». And we explore this signal with a complex approach by using several popular oscillators in our analysis at once.

The boundaries of these relative zones are conventionally denoted by the levels of 20 and 80 on the vertical scale of the oscillator. A sell signal is formed when the oscillator rises above the overbought line, then reverses, and crosses it in the upward direction. A buy signal is formed when the oscillator falls below the oversold threshold and then crosses it up.

In our research, we examine the following widespread oscillators:



In the charts, the overbought/oversold zones of oscillators look like in the following way (the bottom window in the picture):

Formation of a buy signal:

Indicator [2] < Oversold (Indicator in the oversold zone)

Indicator [1] > Oversold (Indicator gets out of the oversold zone)

Formation a sell signal:

Indicator [4] > Overbought (Indicator in the overbought zone)

Indicator [3] < Overbought (Indicator gets out of the overbought zone)

We will test the reviewed signals against a large amount of historical data of various financial instruments and on the basis of two timeframes.

Now, we specify conditions of the opening and closing of a trading position.

The opening of a position:

When a signal is formed, a position opens at the opening of a new candlestick:

• An exit from the oversold zone bottom-up is a buy signal;
• An exit from the overbought zone top-bottom is a sell signal.

The closing of a position:

The lifetime of the position is set at 5 or 10 (in candlesticks) in all cases. 

Having specified all the conditions and set necessary parameters, we can start testing!

The analysis of the obtained results

First, we will estimate the results based on the sample size.

For the H1 timeframe (1 hour):

For the D1 timeframe (1 day):

The total number of candlesticks and events with two timeframes together:

Then, we discover the share of events in % in the total number of initial candlesticks with two timeframes together:

As the result of grouping, we can conclude that irrespective of market segments, the distribution of events under our consideration is almost the same for every oscillator.

Now, we turn to the results of performance of trading signals obtained through oscillator exits from the overbought/oversold zones.

We will assess the results with the two following criteria:

• Momentum (m) reflects the average change in quotes of financial instruments at the moment of fixating a position, in %. A positive value of the momentum indicates profitability of the signal performance, a negative value indicates loss-making.
• SPP, the share of profitable positions, %.

The Momentum in %, the Share of profitable positions in % on a term-to-term basis of the hold of positions and timeframes:

The Momentum in %, the Share of profitable positions in % on a basis of market segments:

We can identify some peculiarities:

• Fixating a position at the 5^th candlestick is more profitable/ less loss-making for all oscillators but the MFI;
• The trading signal over the daily timeframe is more profitable/less loss-making for all oscillators but the RSI.

Let us examine the results on a term-to-term basis of the hold of positions and timeframes.

We take the following notations:

«H1 / 5», the position fixation at the 5^th candlestick over the 1-hour timeframe;

«H1 / 10», the position fixation at the 10^th candlestick over the 1-hour timeframe;

«D1 / 5», the position fixation at the 5^th candlestick over the 1-day timeframe;

«D1 / 10», the position fixation at the 10^th candlestick over the 1-day timeframe;

m, momentum, %;

SPP, the share of profitable positions, %.

The Number of signals, the Momentum in %, and the Share of profitable positions in % on a term-to-term basis of the hold of positions, timeframes, and market segments (the MFI):

The Number of signals, the Momentum in % and the Share of profitable positions in % on a term-to-term basis of the hold of positions, timeframes and, market segments (the RSI):

The Number of signals, the Momentum in % and the Share of profitable positions in % on a term-to-term basis of the hold of positions, timeframes and, market segments (Stochastic):

The Number of signals, the Momentum in % and the Share of profitable positions in % on a term-to-term basis of the hold of positions, timeframes and, market segments (the CCI):

The Number of signals, the Momentum in % and the Share of profitable positions in % on a term-to-term basis of the hold of positions, timeframes and, market segments (DeMarker):

The Number of signals, the Momentum in % and the Share of profitable positions in % on a term-to-term basis of the hold of positions, timeframes and, market segments (WPR):

The Number of signals, the Momentum in % and the Share of profitable positions in % on a term-to-term basis of the hold of positions, timeframes and, market segments (MACD):

Let us summarize the obtained results using the following diagrams:

The highest momentum of 0.041 % is shown by signals of the exit from overbought/oversold zones obtained with the DeMarker oscillator over the 1-day timeframe with the position fixation at the 5^th candlestick.

The lowest momentum of -0.156 % is indicated by signals of the exit from overbought/oversold zones obtained with the RSI oscillator over the 1-day timeframe with the position fixation at the 10^th candlestick.

In general, the momentum of exit signals from the overbought/oversold zones of all oscillators under our consideration is low. So, we can mark the considered signal as ineffective.  

Detailed results are shown in the Appendix:

XLSX (0.10 MB)Application to the article 'Overbought and oversold in oscillators_ Let's check the effectiveness of a popular signal'.xlsx.xlsx