The terms "overbought" and "oversold" are commonly used by analysts
when talking about the condition of the market. These terms appear to
be complex but they can be simple to understand. They are very
important to comprehend when analyzing market movements for trading
Overbought and oversold are used in an analysis of leading indicators,
or oscillators, that describe the areas of market movement in certain
quantities. In addition, these indicators help determine the timing of
when certain trading signals can be entered and exited. The areas of
market movement are either above or below the center line and are
dynamic rather than fixed.
The Relative Strength Index (RSI) is an example of a technical
indicator that was introduced by Welles Wilder. RSI compares the degree
of gains to losses and indicates the strength of security or index
accordingly. Figures ranging from 0 to 100 are used to represent this
information and Welles originally recommended 70 as the value for
overbought and 30 for oversold. The calculated figures are subjective,
but they aim to indicate the levels of entry and exit points for
Depending on the condition of the market, some traders will use an 80
and 40 split while others may use a 60 and 20 split. These splits
indicate the extremes that a market can reach. If the market is
experiencing an uptrend, it can be overbought for a while where as if
the market is experiencing a downtrend, it can be oversold for a while.
These market extremes can also help determine if there is a likelihood
of a reversal. If indicator goes up to the overbought area while the
market is in a downtrend, a reversal can take place. On the other hand,
if the market is in an uptrend and the indicator goes to oversold, a
reversal is just as likely.
RSI is among several other indicators that provide such maximum and
minimum values. Another indicator is the Stochastic, which also aims to
quantify market changes and ultimately helps to verify trading signals.
While the indicators may be similar, they can be different when it
comes to entry and exit points due to the methods of calculation that
Once the overbought and oversold terms are understood, they can be used
effectively and profitably. These terms can be used when talking about
the entire market or certain aspects of it. For the most accurate
results, it is recommended that a few indicators be used to determine
whether the market is overbought or oversold.