Overbought and Oversold Meaning and Example

Overbought and oversold-pic

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:

So, let’s start with the very basics, what are exactly mean by the terms “overbought and oversold”.

Overbought

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.

Oversold

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.

Examples of OB and OS with Indicators:

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 the RSI indicator breaks 70 levels 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

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 are 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 the 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 levels, 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. The overbought or oversold situation does not tell us to enter the trade immediately. Rather it warns traders that a possible reversal is likely to occur.

CCI Indicator (Commodity Channel Index)

The CCI, or Commodity Channel Index, was introduced by Donald Lambert, a technical analyst. It basically measures the current price level relative to an average price level over a specific period of time. The strategy is quite simple, CCI is relatively high when prices are far above their average. And, on the other side, CCI is relatively low when prices are far below their average.

One of the thumb rules for the commodity channel index is that oversold is – 100 and overbought +100.

SBIN cci overbought oversold

Basic Strategy of CCI Overbought Oversold

  • If the CCI moves above +100, a new, as well as strong uptrend, is beginning. This provides signals to buy.
  • Reversely, if the CCI moves below −100, there a strong downtrend is beginning which signals a sell.
  • The above chart is taken from Zerodha kite, here default levels are overbought above +100 and oversold levels below -100. These CCI levels can also be adjusted depending on the volatility of the asset. For instance, for more volatile security you can use +200 and -200.

William % R Indicator

William % R also refer to as the Williams Percent Range, is a kind of momentum indicator that moves between 0 and -100. It is a dynamic technical indicator that determines whether the market is overbought or oversold. The indicator is alike to the Stochastic Oscillator. The only main difference is that %R has an upside-down scale while the Stochastic Oscillator has internal smoothing.

Here, readings from 0 to -20 are overbought, while readings from -80 to -100 is oversold.

William R

Normal Patterns

  • If crossing the overbought boundary from above, the indicator signals a possible sell opportunity;
  • If crossing the oversold boundary from below, the indicator signals a possible buy opportunity.

Divergence patterns

  • If the price climbs to a new high, but the indicator does not this can be a sign of the uptrend weakness;
  • If the price falls to a new low, but the indicator does not this can be a sign of the downtrend weakness.

Overbought and Oversold Meaning FAQ

What does it mean to be oversold?

It is a price state where sellers activities are the highest. Basically, the term oversold refers to a condition where security has traded lower at price. It has the potentiality for a price bounce. When the price is about to left the oversold position, buyers become active from the level. And push the price toward the overbought zone.

What happens when the stock is overbought?

When a stock price is overbought, that means buyers demand reaches the highest peak. And, there is no room for any more buyers. Now, the market is preparing for sellers. An overbought level can be the entry point of sellers. So, it is advisable not to enter with a buy position there.

What is the best overbought/oversold indicator?

There are many indicators or oscillators which indicates the most accurate overbought/oversold level. Among them, there are RSI (Relative strength index), Stochastics, CCI, William % R is the most popular indicators.

How do you know if stock is overbought or oversold?

In order to know if a stock is overbought or oversold, you need to set indicators in your chart. By analyzing indicators like RSI, CCI, Stochastics, etc overbought and oversold levels can easily be defined.

Some More Facts about Overbought/Oversold

Previously, I mentioned that overbought can be a signal of the sellers’ entry point. On the other hand, oversold can be the position of buyers entry. But, sometimes the scenario may not be true. Overbought/oversold can be a long-term scenario. So, make sure, you make an entry in the correct position.

Like here, the overbought level starts on March 1, then it stays on that level almost for a month. This is a daily chart. Let’s see How long it stayed.

So, it is not necessary to make entries once a stock price reaches the maximum overbought/oversold level. Analyze the script properly first then take the decision.

Conclusion

So, Overbought and oversold are such important concepts in the field of technical analysis. Traders get help by identifying these levels. Many oscillators have these levels. If you want to know more about the oscillator follow our blogs daily and get new updates.

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Author: Ankita Sarkar

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. She is a NISM certified Research Analyst. An experienced stock market content writer Ankita is also trading successfully on her own account.

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