The best way to identify overbought and oversold levels is through technical analysis – using price charts and indicators to highlight patterns in market movements. Technical analysis is based on the assumption that historical trends repeat themselves, so previous levels can help predict future movements. Overbought and oversold are terms used to describe extreme price movements in markets. A stock is considered overbought when its price has risen rapidly and above its underlying value, which potentially makes it overvalued. It’s oversold when the price has fallen sharply and below its underlying value, which makes it undervalued. These conditions can signal that a price reversal may be coming, though they don’t guarantee it.

Traders may buy the security when the MACD crosses above its signal line and sell or short the security when the MACD crosses below the signal line. Understanding the broader market sentiment and macroeconomic factors can also be beneficial. A put option gives the holder the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified timeframe. However, it’s important to remember that a stock can remain overbought for an extended period, particularly in a strong bull market.

What Is a Good RSI Indicator?

On the other hand, an RSI reading below 30 indicates oversold conditions, suggesting that the stock is likely to rebound. Being able to recognize overbought and oversold markets is the cornerstone of a sound investment strategy. If you can identify overbought and oversold levels, you will guarantee that you are buying and selling at the best possible price. This scenario signals the end of short-term declines and the beginning of an upward rally.

Overbought indicators, such as the Relative Strength Index (RSI), Bollinger Bands, and Stochastic Oscillator, can be used to identify potential overbought conditions. Traders can use these indicators as part of their analysis to determine if a security is reaching oversold vs overbought a point of potential price decline. However, it’s important to use these indicators in conjunction with other tools and conduct a comprehensive analysis before making trading decisions.

It’s calculated using the ratio of higher closes to lower closes over a specified period, typically 14 periods. The resulting number is then indexed to a value between 0 and 100. Options and futures are complex instruments which come with a high risk of losing money rapidly due to leverage. This information has been prepared by IG, a trading name of IG Markets Limited.

1. This often happens when market sentiment is overly negative, even if the company’s fundamentals remain solid.
2. The idea of the OBV is that a change in price will always follow an increase in trading volume, even if it doesn’t happen right away.
3. This trend is primarily driven by differences in monetary policy approaches.
4. Bollinger Bands are a volatility indicator consisting of a simple moving average (middle band) and two standard deviation lines above and below it (upper and lower bands).

This article represents the opinion of the Companies operating under the FXOpen brand only. This means that if the downtrend is unable to reach 30 or below and then rallies above 70, that downtrend is said to weaken. Sign up for MarketBeat All Access to gain access to MarketBeat’s full suite of research tools. MarketBeat keeps track of Wall Street’s top-rated and best performing research analysts and the stocks they recommend to their clients on a daily basis. Gordon Scott has been an active investor and technical analyst or 20+ years. Take self-paced courses to master the fundamentals of finance and connect with like-minded individuals.

An overbought level can emerge immediately when a financial asset’s price has a parabolic move. You could see a good example of an overbought level in the chart below. The latter gives fewer but stronger signals and is reliable even outside of trending markets, unlike the MACD. If you don’t want to use trading interfaces or anything like that, you can use one of the many available websites that determine whether an asset is oversold or overbought.

The Moving Average Convergence Divergence (MACD) is another popular overbought and oversold indicator. Unlike the RSI, which focuses primarily on oversold vs overbought levels, MACD is more about trend strength and its direction. It shows the relationship between two moving averages of an asset’s price and can help identify potential shifts in momentum. Note that overbought and oversold readings aren’t guaranteed to precede price trend reversals. Overbought levels can be more effective as exit signals for existing long trades rather than initiating short positions, especially for beginners.

On the other hand, an overbought market has risen sharply and is possibly ripe for a decline. Though overbought and oversold charting indicators abound, some are more effective than others. The rise of technical analysis has allowed traders to focus on indicators of a stock to forecast price. Traders use technical tools to identify stocks that have become overvalued in recent trading and refer to these equities as overbought. Another limitation is that RSI may generate false signals, especially during trending markets.

The Stochastic Oscillator is another popular overbought and oversold indicator. If the Stochastic Oscillator is above 80, it is said to be overbought. If the Stochastic Oscillator is below 20, it is said to be oversold. An overbought signal occurs when the current price is much higher than the past prices.

Stochastic oscillator

When using the RSI, you should be aware that the indicator often generates failure swings. It then drops below it for a while and then surges back above without crossing the overbought threshold. We can consider these developments strong confirmations of an upcoming trend reversal.

Conversely, oversold refers to a situation where the price of a stock has fallen too far, too fast, and is likely to rebound soon. Identifying these conditions can provide traders with potential opportunities to enter or exit trades. However, bear in mind that MACD isn’t the most reliable indicator for overbought and oversold markets if used alone.

1. The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.
2. This means that we generally get more reliable signals in daily bars, than 5 minutes bars, just to name one example.
3. In fundamental analysis, such a situation is known as being undervalued.
4. When it comes to finding overbought or oversold stocks, momentum oscillators play a key role.

Stochastics

These swings can take place during uptrends and downtrends, where the former indicates selling activity while the latter represents buying activity. Failure swings occur when the index oscillator doesn’t follow the high point in an uptrend or a low point in the downtrend. Fundamental traders believe that an asset is oversold when its price is lower than its fair or intrinsic value.

Indicators for Overbought and Oversold Stocks

Adjusting the RSI to a shorter lookback period, such as 2-5, can capture shorter-term fluctuations and provide more accurate signals. The ones we presented above are an excellent selection from which to start developing your strategy. We prefer combining oscillators like the Relative Strength Index with trend indicators like moving averages and Bollinger Bands. Therefore, trading overbought and oversold levels require doing more work. First, you need to identify why an asset’s price has reached such a level. Although overbought and oversold signals can help you make up your mind when to enter or exit a trade, they are not 100% reliable — after all, any signal can turn out to be false.