Nov 14 (Reuters) - FX traders must take care not to stretch the elastic too far as the dollar is now overbought and may snap back and sting them on the hand.

Not only is the dollar index overbought on both a daily and weekly basis, but traders have also bought lots of the currency, and the weight of their long positions is much more significant if the rally is stretched.

Should this rise stretch a little further toward last year's peak then the dollar may also become overbought on a monthly basis, as the peak of the 20-month Bollinger bands at 107.44 lies close to 2023's high at 107.34.

At that point the elastic may stop stretching and a reverse may occur.

The alternative is that the elastic snaps and the dollar explodes higher in an impulsive move which would probably include EUR/USD dropping toward or below parity. (EUR is 58% of the USD index)

While this is an exciting and enticing possibility for speculators to consider, it is also far less likely than a correction that unwinds some or all of the extreme situations that have resulted from the dollar's sudden rise.

Unfortunately for gamblers a return to the middle of long-term ranges (circa 1.0750) is more likely. Those not speculating should, and most likely will, hedge in accord with EUR/USD holding above 1.04-1.05.

One factor that must be considered is the significant tightening effect that a rising dollar has for U.S. monetary policy. This will heighten the chance that the Federal Reserves cuts interest rates further or faster, which may bring the dollar back down.

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(Jeremy Boulton is a Reuters market analyst. The views expressed are his own)

((jeremy.boulton@thomsonreuters.com))