Understanding the Meanings of Overbought and Oversold

Technical Analysis | by ForexCycle.com | Sunday, 17 May 2009 01:20 UTC

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 signals.

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 trading.

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 take place.

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.

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