When an asset hits an overbought level, it signifies that price has moved extremely upward from the point where a reversal is likely. In contrast, the oversold level denotes a potential turning point following a strong bearish pressure on the market.
In any instance, extreme bullish or bearish price swings on an asset are a signal to exit the market. However, traders frequently feel perplexed while attempting to distinguish between overbought and oversold signals, which can have an impact on their trading performance.
In the following sections, we’ll go over the key differences between overbought and oversold conditions, as well as how to use them effectively.
What Is the Difference Between Overbought and Oversold?
Overbought and oversold reflect the price of an asset in relation to its intrinsic value. This results in signals expressing market conditions as defined by news, earnings releases, events, and trends.
When an asset is overbought, it signifies the price has been rising for a lengthy period of time. As a result, it is trading at a greater price than its intrinsic value. As a result, traders will come to the conclusion that the asset is overpriced, indicating that a sell-off is imminent. As a result, a reversal and retreat are on the way, and the asset’s price will fall.
An oversold market suggests that an asset is trading for less than its present value. This occurs when an item is sold at an undervalued price over an extended period of time, indicating that it has already reached its all-time low. In contrast to an overbought market, an oversold market frequently results in an upward-direction rally, causing the asset’s price to rise.
Overbought vs. Oversold on Price Chart
When you stretch the rubber band and then release it, it will return to its original position. The rate at which it does so is determined by how far you’ve stretched it. The more you stretch, the faster it returns to its previous position.
Similarly, when the current trend advances to the overbought or oversold zone, the price has a larger chance of returning to the equilibrium zone.
Let’s look at a real-world example of an overbought price:
The preceding chart illustrates that the price is heading higher with strong bullish pressure and no pullback, indicating that the price is overbought.
Now consider the following example of an oversold price:
We can observe that the price is heading lower with significant negative pressure, with no correction, indicating that it is oversold.
How to Determine Whether a Market is Oversold or Overbought
We saw in the last part that sustained movement to the downside or upside is termed an oversold or overbought price.
But how can you determine the level from which the reversal is possible? Is it necessary to use overbought or oversold indicators?
To begin, we may identify an overbought or oversold level simply by looking at the naked chart. The concept is that as the price rises and encounters strong resistance, it will be driven down and, with support, will steadily climb, as illustrated in the graphic below:
This strategy does have one disadvantage, though: we are unsure of whether the price will revert from the horizontal level or not. As a result, traders employ technical indicators to raise their chances of identifying an overbought or oversold market.
Identifying Overbought and Oversold Conditions Using the Stochastic Oscillator
Readings between 0 and 20 on a stochastic graph are regarded as oversold, whereas readings between 80 and 100 are overbought. According to the analytical theory of support and resistance, a price will retrace when it approaches an extremely overbought or oversold barrier. As a result, overbought stochastic readings are perceived as bearish (sell) signals because it is predicted that the price momentum will change. In contrast, oversold readings are viewed as bullish (buy) signals since they imply a potential increase in price momentum.
Nevertheless, a reading of 80 or below or one above or below 20 does not automatically imply a call to buy or sell. In rare cases, if the price trend is strong enough, an asset could stay overbought or oversold for a considerable amount of time (i.e., the price continues to close at higher highs or lower lows). The stochastic oscillator in the figure below crosses over 80, indicating a sell signal, but the price keeps rising, and the asset stays in the overbought region for a few days. The trader would have had to take a loss or close the position before the trend turned in their favor if they had opened a short position when the oscillator first moved over 80.
Limiting your risk exposure and avoiding premature trade entry are two benefits of investing in the direction of the strong trend. Examine your price action graph and use a trend indicator, such as the moving average convergence/divergence (MACD), to check the direction and intensity of the current trend before acting on overbought and oversold readings.
Traders often search for divergences and signal line crosses to further corroborate the buy and sell signals given by overbought and oversold stochastic readings. When the price movement achieves a new high or low extreme while the stochastic oscillator does not, a divergence takes place. Because price momentum (as gauged by the stochastic oscillator) is known to change direction before the price itself, a divergence will typically come before a trend reversal. For instance, the stochastic oscillator fails to generate a lower low than earlier readings in the graphic below where the price makes a new low.
The two stochastic signal lines cross at the moment of this divergence, providing still more clue that the trend is about to reverse. The trader should wait to confirm a matching shift in price before taking a long position. The price fails to produce a lower low right after the divergence and instead keeps climbing in the opposite direction, confirming the reversal.
Identification of Overbought and Oversold Conditions Using the RSI
Because the RSI does not employ a simple moving average as a second signal line, it cannot be utilized to detect crossings, in contrast to the stochastic oscillator. The RSI gauges price momentum and is used to spot overbought and oversold signals despite using a distinct analytical technique. RSI values above 70 are typically regarded as overbought, and readings below 30 are commonly regarded as oversold, despite the fact that the stochastic oscillator and the RSI have the same visual range (as opposed to 80 and 20 on the stochastic oscillator).
It is believed that the trend will change, and the price will decline, when the RSI rises over 70 and then drops back below this oversold level. This assumption assumes that the RSI movement is bearish. Similar to this, it is interpreted as bullish, predicting a matching rise in price, when the RSI crosses back above the 30 line after falling below 30.
Similar to the stochastic oscillator, risk should always be minimized by considering RSI buy and sell signals in the context of the current trend. A trader should disregard oversold readings that conflict with the existing trend, for instance, if a price is establishing a strong rally, until they can verify a corresponding trend reversal. While it is possible to make money by acting on overbought and oversold readings that go against the general market trend, this approach necessitates traders to make quick entries and exits and, ultimately, results in traders taking greater risks for a smaller potential benefit.
Failure swings are additionally employed to locate price trend reversals. A failed swing is when the RSI spikes above 70, settles below 70, and then rises once more without exceeding the overbought line. The same is true when the RSI crosses the oversold line, then goes below 30, rises above 30, and then crosses it again without crossing it.
Stochastic Oscillator vs. RSI: When to Use Which?
Given that the stochastic oscillator and the RSI have different characteristics, it is important to understand when each indicator is more accurate and valuable than the other.
In general, stochastic oscillators perform better as indicators in choppy markets with irregular price changes. The stochastic oscillator can provide insight into non-mainstream forex assets whose price movements have little to no relevance to previous activity because it doesn’t rely on trending information to determine overbought and oversold circumstances.
The RSI, on the other hand, makes advantage of this trending data, making it a subpar indicator to employ when there is erratic price activity. However, it can be a more useful indicator than the stochastic oscillator for important currency pairings.
Identification of Overbought and Oversold Conditions Using the Parabolic SAR
Although it is not a widely used tool for this purpose, many experienced traders use it to identify overbought and oversold markets. If you are just getting started, you should stick with the RSI or the Stochastic Oscillator because it takes time to learn how to read the indicator’s signals.
To help spot overbought and oversold positions, the Parabolic SAR indicator tracks price fluctuations and their pace. SAR refers for “stop and reverse” in the name. The term “parabolic” refers to how the indicator’s computations collectively take the form of a parabola.
Because it provides information about the market’s general health and the speed at which price fluctuations occur, the parabolic SAR is a favorite trading indicator.
On a chart, the indicator shows as a group of dots next to the price bars. During bullish trends, the indicator is below the price, while during negative trends, it is above the price.
There is a higher likelihood of abrupt, decisive price changes the farther apart the individual dots are from one another (overbought and oversold zones). The proximity of the dots to one another suggests that momentum may be slowing down.
Keep in mind that when a trend reverses, the indicator moves slowly for the first few periods (the dots are very dense). The indicator picks up pace and catches up with the price as the trend intensifies.
Finding Overbought and Oversold Conditions Using the Fibonacci Retracement
Fibonacci retracement levels are well-known to traders, but these lines of support and resistance can also be helpful in determining overbought and oversold situations based on previous chart moves.
The Dow Theory of retracement is the most popular method for using Fibonacci retracements to spot overbought and oversold circumstances. According to this hypothesis, after an initial price movement, the price will typically retrace by about 50%. This 50% point lies exactly between the Fibonacci retracement levels of 38.2% and 61.80%, which serve as the ends of a wider “zone” of projected retracement.
When traders make a commitment to reaching certain retracement levels before they close their position and take a profit, they run the risk of getting into difficulty. Instead, the Dow Theory would advise opening a position after overbought or oversold conditions emerge and then aiming for a position inside the range of 38.2 percent to 61.8 percent as the optimal use of Fibonacci retracement. As soon as you reach this area, think about utilizing stop-losses to protect your gains while continuing to pursue more gains through deeper retracement.
When an item frequently encounters a line of resistance, it may be a sign of overbought circumstances, which can cause a price decline. Similar to the parabolic SAR, the stochastic oscillator and Fibonacci retracement work well together to confirm the correlation between retracement and overbought or oversold circumstances.
A straightforward ABCD Fibonacci retracement pattern and an oversold stochastic signal for the NZD/USD currency pair can be seen in the chart below:
Fibonacci retracements might be useful for determining overbought and oversold circumstances if you’re already familiar with using them for other chart analyses.
Identification of Overbought and Oversold Conditions Using the Bollinger Band
One of the simplest indicators to employ when searching for overbought and oversold signals is the Bollinger Bands. Three lines make up the indicator’s pricing channel, all of which employ the 20-day SMA.
The market is deemed “overbought” and a bearish signal is given if the price breaks the top line. In that situation, you can anticipate a downturn, making now the ideal time to sell.
However, if the price breaks the lower line, the market is oversold, and a positive rally is expected. Typically, this is the ideal time to purchase.
Before opening a position, make sure to wait for a complete candle to validate the indication to close. You can see from the aforementioned example that the lines are initially broken by a bullish candle in the “overbought” scenario. The price decline, however, begins when a bearish candle ends. The upside rally starts with the first bullish candle in the oversold circumstance, and vice versa.
How to Determine Overbought and Oversold Conditions with the Commodity Channel Index (CCI)
By contrasting the present-day price swings of the instrument with its past ones, this momentum oscillator aids in the identification of overbought and oversold markets. Don’t be fooled by the indicator’s name; you may use it on a variety of assets, including stocks, foreign exchange, and more.
The initial goal of the indicator was to lessen the uncertainty brought on by cyclical and seasonal commodity markets. Today, it is an excellent tool for identifying impending trend reversals.
The indication can be represented on a chart as a line inside a box. The CCI swings back and forth between -100 and +100. The market is thought to be either overbought (when over +100) or oversold whenever the indicator departs from this range (when below -100).
Traders can sell in anticipation of a negative trend when the price rises above +100 and then falls back below it. As a result of the overwhelming bullish mood, traders might purchase when the indicator falls below -100 and then rises back above it.
The first time the indicator surpasses either of the levels, trade should be avoided. The reason is that overbought and oversold circumstances may last for a long time during strong movements. As in the Bollinger Bands example, ensure that the following candles confirm the trend.
The -100 and +100 ranges of the CCI are not immutable, which is another important fact to be aware of. The outcomes can vary depending on the asset. Before placing your trades, make sure you are familiar with the historical values to receive a realistic picture of the precise reversal points.
Identification of Overbought and Oversold Conditions Using the On-Balance Volume (OBV)
The volume flow used by this momentum indicator allows traders to spot overbought and oversold markets. By reflecting audience sentiment and gauging buying and selling pressure, it foretells bullish and bearish reversals.
According to the OBV, even if it takes some time, a shift in price will always come after an increase in trade volume.
It is necessary to keep an eye on both the movement of the OBV and the price behavior in order to use the indicator to spot overbought and oversold markets. A hallmark of an overbought market is when the price hits greater highs but the OBV makes lower highs. A price reversal and a downward surge are to be anticipated; now is the ideal time to sell.
How to Determine Overbought and Oversold Conditions using the Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence is another indicator that can identify overbought and oversold markets. The MACD generates a signal line that assists traders to spot buy and sell signals by mimicking the relationship between the 12-day and 26-day exponential moving averages.
Traders watch for when the MACD crosses below the signal line to identify overbought markets. When the market is anticipated to move upward at that time, there may be a chance to buy. The market is deemed “overbought” and you should proceed to sell to prevent suffering financial losses as a result of the impending downward price movement, on the other hand, if the MACD falls below the signal line.
But keep in mind that when used alone, MACD isn’t the most accurate indicator for overbought and oversold markets. To more accurately check the strength of the trend and identify divergences, make sure to combine it with a second indicator, such as the Relative Strength Index or the Stochastic Oscillator.
To validate accurate entry and exit points, you can additionally combine it with the Parabolic SAR.
Identification of Overbought and Oversold Conditions Using Price Action
Price action is the finest technical indicator for determining oversold and overbought price levels. This indication is more complicated than the RSI and Stochastics indicators, making it difficult for novice or intermediate traders to employ.
Discovering overbought and oversold conditions can be done in a variety of ways. I’ll provide a quick procedure to figure this out.
A competent trader can identify the oversold and overbought areas on the chart with only a quick glance, so it also relies on how much time they spend watching the chart.
- On the candlestick chart, use the HH HL (higher high, higher low) and LL LH (lower low, lower high) strategies.
- The price is in an overbought position if the candlestick chart shows eight successive higher highs and higher lows. On the other hand, if there are eight successive lower highs and lower lows, the price is oversold.
To understand this idea better, look at the picture below.
Is MACD Better Than RSI Reading?
To identify a price reversal point, overbought/oversold indicators such as the relative strength index and moving average convergence divergence (MACD) can be used. The RSI indicator, as opposed to the MACD, does, nevertheless, display a more trustworthy result.
According to statistical evidence, RSI outperforms MACD in terms of success rate and false signals. On the other hand, MACD performs admirably in particular trading contexts. Other elements maintain RSI ahead of MACD.
These elements are listed below:
- While MACD is effective in trending markets, it produces less reliable signals in corrective or choppy markets, when RSI performs better.
- The strength of the RSI indication is still significant despite the fact that RSI offers less signals than MACD in terms of signal numbers.
- Furthermore, RSI outperforms MACD for fundamental analysis.
- In order to reduce the number of trades and improve accuracy, RSI is preferable to MACD in the crypto market.
Overbought and Oversold Levels: How Reliable Are They?
Technical analysis is used in financial market trading to forecast price movement based on historical price data. We want to concentrate on improving our chances of success as much as we can as we trade on probability.
Our primary goal when considering overbought and oversold levels is to incorporate these levels into our trading strategy and maximize the likelihood of generating steady gains. However, there is a greater chance that you will lose money if you try to rely just on the stochastic indicator or the RSI indications.
What is the oscillators’ best application, then?
The best method is to combine oscillators with price movement analysis as a secondary confirmation.
As an illustration, if you trade price action, you most likely recognize the market trend and only enter a trade when the price climbs upward from the support level inside a bullish trend.
In that instance, you can consider the bullish chance as strong if the price rises from the support level and the RSI also rises over 30.
When reliability is taken into account, overbought and oversold levels are simply included into trading strategies. To attain your financial objectives, you must use additional technical tools. The majority of momentum indicators perform best when price movement is trend-conforming. The price, however, is always the most important item you can add to your trading toolbox.
How to Use Overbought and Oversold Levels in Trading
Using metrics like overbought and oversold levels, trading in the financial market necessitates a pragmatic approach to making money. You are prepared to profit from trading if you can combine all of your knowledge into an overbought and oversold strategy.
Let’s take a look at a trading method that uses overbought and oversold levels and is profitable.
Technical Indicators Used
- Simple Moving Average (SMA) — value 200
- Exponential Moving Average (EMA) — value 20
- Stochastic Oscillator
Making a Buy/Sell Trade
- The price is in a bullish long-term trend if it is trading above SMA 200. The long-term trend will also be bearish if the price is trading below SMA 200.
- For a purchase, the 20 EMA should be above the 200 SMA, and for a sell, it should be below the 200 SMA.
- Find a price that is below the 20 EMA but above the 200 SMA, and then wait for the stochastic oscillator to move up from 20 before entering a buy trade.
- To place a sell trade, on the other hand, make sure the price is beneath the 200 SMA and the stochastic oscillator has descended from 80.
Case Study Example
Check out the steps for making a buy trade from the oversold level below:
In the figure above, the price has dropped below the 20 EMA, indicating short-term selling pressure, and the overall market trend is bullish. The stochastic indicator rises above 20 when the market is bullish, and the price rises as soon as a candle closes.
The take profit is predicated on the significant near-term resistance level, and the stop-loss level is below the most recent swing low.
The bearish case scenario and how to open a selling trade will now be discussed.
The price has gone above the 20 EMA in the preceding chart, signaling short-term buying pressure. The overall market trend is bearish.
The stochastic oscillator has gone below 80, signaling a negative market overall, and the price swings lower as soon as a bearish candle closes. The take profit is predicated on a short-term crucial support level, and the stop-loss level is above the most recent swing high.
Conclusion
What we know about overbought and oversold signals can be summed up as follows:
- A possible price reversal can occur from an overbought or oversold level, which functions as a major price zone.
- Any financial market, including those for forex, equities, cryptocurrencies, and indices, can use these levels.
- Employing technical analysis, which involves looking at the chart and using indicators, it is possible to identify the overbought and oversold levels.
- The stochastic oscillator and the RSI are two well-known overbought and oversold indicators.