Overbought and Oversold Meaning and Example

A regular investor must be familiar with the terms Overbought and Oversold in the stock market. These are the two significant phases of a market movement. Find out a proper Entry time considers as the most important decision in trading. When OB or OS situation reaches the extreme point, the reverse trend appears. To become a successful trader identify the OB and OS situation is one of the main points. In “Overbought and Oversold Meaning” we are going to simplify the terms and state indicators which help to identify the situations.

Overbought and Oversold Meaning:

The term “overbought” itself carries the meaning of it, it indicates a situation in which the demand for a specific asset pushes the price and has enjoyed a prolonged period of rising prices. However, determining the degree at which an asset is OB is very much subjective and can differ among investors.

On the other hand, “oversold” indicates a phase when investors try to sell their stocks to book profit. The price of an asset has fallen drastically because of the market overreaction or panic selling. In that case, the asset has suffered a short-term or prolonged period of falling prices.

Indicators to Identify OB and OS situation:

The price can’t move in one direction forever, it will definitely turn around at some point. The OB or OS situations sometimes consider as the market correction. There are numbers of technical analysis methods by which one can identify the situations. But among these RSI (Relative Strength Index) and the Stochastic Indicators are generally and effectively used by the investors. Therefore, let’s move on to the methods of identifying the phases by applying these two indicators.

RSI (Relative Strength Index)-

The relative strength index also refers to the momentum oscillator, developed by J. Welles Wilder. It is a range-bound oscillator which fluctuates between 0 to 100 depending on the market performance. The higher the RSI, the stronger the bullish trend and vice versa. RSI movements above 70 or 80 consider as overbought and when RSI moves below 30 or 20 indicates the oversold situation. The default setting for the RSI indicator suggested by Wilder is 14 periods.

Overbought and Oversold Meaning

In the above chart, we can see RSI indicator breaks 70 level and creates an overbought phase. It is advisable not to sell immediately as we don’t know how far the price could continue to rally. Traders should wait till the RSI falls back below 70. This can give a good entry point with a profitable trade.

Oversold

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The above chart shows clearly that RSI drops below 30, knows as the oversold situation. Investors are advised to wait until the RSI crosses back above 30.

Stochastic Indicator-

The stochastic indicators is also a range-bound oscillator like RSI. There is a slight difference between them. Stochastic indicators compare the current price level to its range over a specific period of time while RSI is measured based on the average gains or losses. A stochastic value above 70-80 is considered an overbought situation and values below 30-20 shows oversold status.

Stochastic Indicator

The chart shows stochastic indicator with the overbought and oversold situation.  Here the stochastic indicator breaks the level of 80 to create an overbought phase and when it crosses the 30 level, an oversold situation appears.

However, overbought and oversold meaning carries a significant role in trading. Investors must be aware of these situations to make a proper entry for a profitable return. Overbought or oversold situation does not tell us to enter the trade immediately. Rather it warns traders that a possible reveral is likely to occur.

Ankita is a graduate in English language and she has also done her MBA from the Calcutta University. She has a high knack in the stock markets. An experienced stock market content writer Ankita is also trading on her own account. Ankita is also preparing for the NISM Research Analyst Series XV examination seriously.



Categories: Stock Market Basics

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