If markets were completely efficient, stocks would likely reverse course long before they entered overbought or oversold territory as rational investors took profits. But when a stock makes a parabolic move (especially to the upside), it’s hard for investors to separate emotional thinking from careful investment planning. Overbought means excessive optimism is setting in; likewise, pessimism with oversold securities. Thankfully, investors have tools that provide hints when a soaring stock is due for a decline or if a beaten-down stock is due for a bounceback. These are known as overbought or oversold conditions, and technical analysis is used to locate them.
This article explores what overbought and oversold stocks are, how to find them using technical indicators, and the risks involved in trading them. Understanding overbought and oversold stocks, along with the indicators used to identify them, can help traders spot potential market opportunities. While these conditions may signal a reversal, it’s important to recognise there is no one best overbought and oversold indicator and use multiple tools for confirmation. Open an FXOpen account today to access more than 700 markets, including a huge range of stock CFDs, and four advanced trading platforms.
For example, you could wait for the RSI to move out of the overbought or oversold territory or for the price to break out of the consolidation pattern. There are many different ways to identify overbought and oversold signals. Some of the most popular methods include technical indicators, such as the Relative Strength Index (RSI) or the Stochastic Oscillator.
What Is an Oversold Stock?
It is calculated with the help of average gains and average losses—made by the stock in the recent 14 periods. Traders can use various technical oscillators to study the pattern of stock price movement—Relative Strength Index (RSI) ans stochastic oscillator. Traders make crucial buying and selling decisions based on those patterns. Traders take either a short or long position to reap maximum benefits from overbought or oversold securities.
Indicators Used to Spot Overbought/Oversold Conditions
The Stochastic Oscillator, being much more sensitive to the latest price action, will throw out signals far more often. You’ll see its line dart from overbought to oversold and back again more frequently, even on minor price wiggles. The core difference in the overbought vs oversold debate is pretty simple. On the flip side, an oversold market is where panicked selling has hammered prices down so far, so fast, that a rebound feels almost inevitable. Given its sensitivity, it’s common to see the Stochastic signals a market is overextended for a longer period when there’s a strong trend. This makes it more prone to false signals than the RSI or MACD indicator and typically more useful for trading pullbacks in a broader trend.
What does Overbought and Oversold Mean for Traders?
Oversold conditions can present opportunities for entering long positions, particularly when prices show signs of stabilising. Risk management becomes especially important during overbought conditions. Traders should consider tightening stops and reducing position sizes until the market direction becomes clearer. Spread betting traders often use multiple timeframes to confirm signals. This helps avoid false readings that could trigger premature position exits.
Like the RSI, it swings between 0 and 100, but extremes are viewed differently, as readings above 80 are considered overbought and below 20 oversold. Naturally, this strategy can work in reverse too, with the RSI indicator signalling oversold conditions before the reversal of a downtrend. Bollinger Bands are another indicator that can be superimposed over price action candlesticks to reveal overbought or oversold conditions. The Stochastic Oscillator was developed in the 1980s as a momentum indicator to identify overbought and oversold conditions. Traders use indicators to signal when an asset has entered either overbought or oversold territory. Conversely, in a bear market where prices are falling over a longer period of time, trigger lines of 20 and 60 can be used.
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When the MACD line diverges significantly from its signal line and moves above or below a certain threshold, it may signal overbought or oversold conditions. The MACD indicator is another way to identify overbought or oversold conditions, by comparing two moving averages. We explain how to use indicators to recognise these market conditions, and look at some trading strategies you can use when you identify such market conditions. In this lesson, we take a deep dive into overbought and oversold market conditions, and explain exactly what they mean and how to trade them. This proves the strength of the upward movement and we might as well avoid going against the trend in such strong movements. Periods of overbought and oversold may take longer to turn around than it does for you to remain solvent.
The relative strength index provides short-term buy signals and sell signals. However, we must twist the preconceived idea that an overbought stock will inevitably turn downward and vice versa. On the contrary, stocks can continue to rise despite being overbought. Have you ever heard in an analysis, an analyst advises this or that stock to sell since it was overbought and on the contrary to buy since it was oversold. This is generally seen as a buying signal.The price of the asset is devalued and therefore there is a buying opportunity. From a technical analysis perspective, this is a situation where the price of an asset has fallen so much that the oscillator has reached its lower bound.
An overbought signal in a raging bull market is usually just a sign of incredible strength, not a sign of a top. On the flip side, an oversold signal becomes much more potent when it lines up with a major historical support level. Easily the most expensive mistake is taking an indicator signal in a vacuum.
What Are Overbought and Oversold Conditions
- Ultimately, understanding the personality of each condition helps you contextualize price action and anticipate potential shifts in momentum before they happen.
- It is important to remember that overbought and oversold signals should be just one part of your overall trading strategy.
- Like the RSI, the stochastic moves on a scale between zero and 100.
- This can lead to the asset trading at a higher price than it is currently worth.
While the relative strength index is calculated based on average gains and losses, stochastics compares the current price level to its range over a given period of time. Stocks tend to close near their highs in an uptrend and near lows in a downtrend. Therefore, price action that moves further from these extremes toward the middle of the range is interpreted as an exhaustion of trend momentum. Combining RSI and stochastics with other indicators improves decision-making for identifying buy and sell points. Stochastics evaluate price position within its range; values above 80 are overbought, and below 20 are oversold.
Overbought signals in an uptrend may suggest exiting a long trade, while overbought signals in a downtrend or sideways trend may suggest a short sell position for traders. A stochastic value of 100 means that prices during the current period closed at the highest price within the established time frame. A stochastic oversold vs overbought value of 80 or above is considered an indication of an overbought status, with values of 20 or lower indicating oversold status. RSI levels of 80 or above are considered overbought, as this indicates an especially long run of successively higher prices.
- Tools like the Relative Strength Index (RSI) and stochastics are used in technical analysis to spot these conditions.
- These signals tend to be most reliable in ranging markets rather than strong trends.
- Oversold signals in an uptrend may suggest entering a long trade, while oversold signals in a downtrend or sideways trend may suggest an exit sell position for traders.
- Naturally, this strategy can work in reverse too, with the RSI indicator signalling oversold conditions before the reversal of a downtrend.
This can then mean that the price of the asset is overvalued and could experience a pullback. Market conditions and moving averages are factors that can help identify when a stock is overbought or oversold. How to determine if an asset is oversold or overbought in the market? Another way to think of “overbought” is “overvalued.” This means that the price of the stock is too high compared to other value metrics or previous prices. There is a strong likelihood that the price could drop to correct the demand.
If you want to find out more about technical indicators, I’ve written an article on the 12 best indicators to use for forex trading. There are several well-known indicators which you can use to illustrate these market conditions. Both retail and prop traders use these market conditions as an entry signal or ‘trigger’ to place a trade. An asset that is either overbought or oversold is often about to change direction, and so is ripe for trading either up (with a long trade) or down (with a short trade.) The term ‘overbought’ refers to a period where the price of an asset has risen significantly and quickly, potentially reaching a level higher than its intrinsic value.
Overbought and oversold conditions help traders identify potential market reversals. Learn how to spot these signals and use them in your trading strategy. Two of the most common charting indicators of overbought or oversold conditions are relative strength index (RSI) and stochastics. Welles Wilder Jr. and introduced in the 1978 book “New Concepts in Technical Trading Systems,” RSI is a measurement of stock price change momentum. Instead of seeing extreme readings as reversal signals, you view them as trend confirmation.