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Last updated on May 27th, 2024
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Cate Cook

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Cate Cook
Cate is a journalist by profession who started trading shares in 2008, after which she became a full time CFD day trader for more than 10 years. She now combines her passions for writing and trading at MarketMates. Join the blog to receive the latest articles from Cate.
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Sam is the Cofounder and CEO of MarketMates. He has traded since 2008 and is the Author of the Amazon best-seller The Consistent Trader. Over 42,000 traders have taken his Advanced Forex Course for Smart Traders. Join the blog to get his latest articles.
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What does Overbought and Oversold Mean for Traders?

Find out what overbought and oversold means and how to trade these conditions

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At MarketMates, we are committed to providing accurate information. Our content undergoes a rigorous process of fact-checking before it is published. Learn more about our editorial policy.

In this article

The terms ‘overbought’ and ‘oversold’ are commonly used in the trading world.

In this lesson, I take a deep dive into overbought and oversold market conditions, and explain exactly what they mean and how to trade them.

I explain how to use indicators to recognise these market conditions, and look at some trading strategies you can use.

What does overbought and oversold actually mean?

Overbought:

The term ‘overbought’ refers to a period where the price of an asset has risen significantly and quickly, potentially reaching a level higher than its intrinsic value.

This condition is often interpreted as a signal that the asset may be overvalued, and there is a possibility of a price correction or reversal in the near future.

By describing the asset as ‘overbought’, there’s an implication that too many buyers have purchased it, raising its price to an unsustainable level.

Put simply, overbought means the asset’s price has risen too far, too fast, and may be due for a correction.

Oversold:

‘Oversold’ describes a situation where the price of an asset has declined significantly and rapidly, potentially reaching a level lower than its intrinsic value.

In this scenario, there is a perception that too many sellers have exited their positions, causing the selling pressure to be excessive, leading to a sharp drop in price.

Therefore, the asset may now be undervalued and due for a price bounce back.

What are the implications of an asset being overbought or oversold?

An asset that is either overbought or oversold is often about to change direction, and so is ripe for trading either up (with a long trade) or down (with a short trade.)

Many traders use these market conditions as an entry signal or ‘trigger’ to place a trade.

Therefore, overbought and oversold indicators can generate trade entry signals for traders who are looking for trend changes.

How to identify overbought and oversold market conditions

Traders use indicators to signal when an asset has entered either overbought or oversold territory.

There are several well-known indicators which you can use to illustrate these market conditions.

Some are more effective than others at doing this job.

If you want to find out more about indicators, I’ve written an article on the 12 best indicators to use.

The ones I’ll concentrate on today are:

  • Relative Strength Index (RSI)
  • Moving Average Convergence Divergence (MACD)
  • Stochastic RSI Index
  • Bollinger Bands

Using the Relative Strength Index indicator

The RSO index was created by analyst J. Welles Wilder and introduced in 1978 in his book ‘New Concepts in Technical Trading Systems.’

The RSI index is usually displayed as a single line indicator (known as a signal line) below standard candlestick price charts.

Here’s an example of the RSI moving into overbought territory during an uptrend:

RSI Overbought and oversold example

The RSI calculation, in simple terms, compares the chosen period’s average bullish days against its average bearish days and displays them on a scale of 0 – 100.

Normal price action is at the halfway point on the scale, at level 50. This is the middle dotted grey line in the diagram above.

Above and below the middle line are two additional indicator lines (the upper and lower dotted lines forming the band).

These are usually set at the points 70 and 30.

The RSI is traditionally used:

  • as an overbought indicator when the reading is above 70
  • as an oversold indicator when it is below 30

This means when the line rises to a value above 70, the asset is considered overbought. When it drops below 30, it is considered oversold.

In the illustration above, the indicator has risen above the 70 line, indicating overbought conditions (the portion shaded green.)

Moving Average Convergence Divergence (MACD)

A MACD indicator is another way to identify overbought or oversold conditions, by comparing two moving averages.

This indicator was invented by famous technical analyst Gerald Appel in the 1970’s.

The Moving Average Convergence Divergence (MACD) indicator consists of three main components:

1. The MACD line

This is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA.

This line represents the difference between the short-term and long-term moving averages and serves as the primary indicator of trend direction and momentum.

2. Signal Line:

The signal line, also known as the MACD signal or trigger line, is a 9-period EMA of the MACD line.

It smoothens out the MACD line and provides signals for potential trend changes.

3. Histogram:

The histogram is derived from the difference between the MACD line and the signal line.

It represents the distance between these two lines and provides visual confirmation of momentum strength.

When the MACD line diverges significantly from its signal line and moves above or below a certain threshold, it may signal overbought or oversold conditions.

MACD Overbought or oversold

Stochastic RSI Index:

The Stochastic Oscillator was developed in the 1980s as a momentum indicator to identify overbought and oversold conditions.

The Stochastic RSI (Relative Strength Index) is a technical indicator that combines elements of both the Stochastic Oscillator and the RSI.

It is designed to provide more sensitive and accurate signals for identifying overbought and oversold conditions in the market than either of these indicators alone.

This indicator compares an asset’s closing price to its price range over a specific period.

When the Stochastic Oscillator rises above 80 or falls below 20, this may suggest overbought or oversold conditions.

  • Overbought conditions: When the Stochastic RSI rises above 80 it indicates that the RSI is overbought, suggesting a potential reversal or pullback in the price.
  • Oversold conditions: When the Stochastic RSI falls below 20, it suggests the asset is oversold, signalling a potential rebound or rally in the price.

The Stochastic RSI Index shows overbought conditions in an uptrend and oversold in a downtrend.

Bollinger Bands

Bollinger Bands are another indicator that can be superimposed over price action candlesticks to reveal overbought or oversold conditions.

You can find out lots more uses for Bollinger Bands on our page dedicated to this subject.

They consist of a simple moving average (SMA) in the middle, with an upper band representing two standard deviations above the SMA, and a lower band representing two standard deviations below the SMA.

  • When the price of an asset touches or exceeds the upper band, it suggests that the asset may be overbought.

This means that the price has moved significantly higher than its typical range, potentially signalling a reversal, or a period of consolidation.

  • Conversely, when the price of an asset touches or falls below the lower band, it indicates that the asset may be oversold.

This suggests that the price has fallen significantly below its typical range, possibly indicating a reversal.

Bollinger Bands indicating both overbought and oversold conditions:

Bollinger Bands overbought and oversold

Using overbought and oversold indicators

Traders use overbought and oversold indicators to identify potential market turning points.

It doesn’t matter which indicator you choose to use.

The most important decision you will need to make as a trader is how you use overbought or oversold indicators to enter and exit a trade.

Strategies for forex traders

Here are a couple of suggestions for using overbought and oversold conditions as an entry strategy for a trade:

The Bollinger Band Bounce strategy

The Bollinger Band Bounce is a forex trading strategy that uses the Bollinger Bands indicator to identify potential price reversals.

Here’s a breakdown of the strategy.

The strategy in action:

Buy Signal

The strategy assumes that prices tend to revert back to the mean (middle line) after deviating significantly.

So, a buy signal is generated when the price touches or falls below the lower Bollinger Band.

The expectation is that the price will bounce back upwards towards the middle line.

 

Sell Signal

A sell signal is generated when the price touches or rises above the upper Bollinger Band.

This suggests a potential price reversal downward towards the middle line.

Additional Considerations:

  • Band Width: The Bollinger Bands widen when price volatility increases and contracts during periods of lower volatility.

Ideally, the strategy works best when the bands are stable or contracting, indicating a potential return to the mean.

Expanding bands might suggest a trend instead of a reversal.

  • Confirmation: Some traders prefer to combine the Bollinger Band Bounce with other technical indicators, like support and resistance levels or candlestick patterns for additional confirmation before entering a trade.
  • Exit Strategy: Having a clear exit strategy is crucial. This could involve taking profits at a certain pip target above/below the middle line, using a stop-loss order to limit potential losses, or trailing stop-loss orders that adjust as the price moves in your favour.

Limitations to this strategy:

The Bollinger Band Bounce is a relatively simple strategy, and doesn’t account for all market factors.

False signals can occur, especially during strong trends or volatile markets.

Here is an example of a Bollinger Band Bounce failing:

Bollinger Band failed breakout

Using the RSI indicator and candlestick reversal pattern strategy

Another strategy that forex traders can use is the RSI indicator showing overbought or oversold conditions, in conjunction with a candlestick reversal pattern.

In this example of a short trade, the RSI indicator signal line goes above 80, signifying overbought conditions.

This is confirmed by a red spinning top candlestick at the top of the uptrend, warning of a price reversal.

RSI with candlestick reversal

The strategy in action

Sell signal:

The strategy combines the Relative Strength Indicator (RSI) with a candlestick reversal pattern to generate a sell signal for a short trade.

A sell signal is generated when the RSO indicator shows an overbought condition (typically above 80), and a bearish candlestick reversal pattern, such as a spinning top or a doji at the top of the uptrend.

Buy signal:

The buy signal is generated when the RSI indicator returns to the middle indicator line.

Additional considerations:

Indicator alignment: Ensure that the RSI indicator and the candlestick reversal pattern align for stronger signals. This combination increases the likelihood of a successful trade.

Trend context: This strategy works best in ranging markets or during periods of consolidation. In strong trending markets, the effectiveness of the RSI indicator and candlestick patterns might diminish.

Naturally, this strategy can work in reverse too, with the RSI indicator signalling oversold conditions before the reversal of a downtrend.

The example below shows the RSI indicator going into oversold territory below 20, and a doji candlestick warning of a trend reversal, which could be a buy signal for a long trade.

RSI oversold and reversal

Your choice of indicator

Of course, any overbought or oversold indicator you use can be as effective as using Bollinger Bands.

For example, you may prefer to use Donchian Channels, the Ichimoku Cloud or the Supertrend Indicator to show you when an asset is overbought or oversold.

There is no right or wrong choice about the indicator you use.

What is more important than your entry point is your trade position size and your risk management.

If you want to learn more you can get 100% FREE access to:

The Advanced Forex Course for Smart Traders

Till next time, happy trading!

Cate

Get this week's best trading content

Lessons for all levels of trader. Nail the basics, master your mindset and learn advanced techniques.

Cate Cook

Cate Cook

Cate is a journalist by profession who started trading shares in 2008, after which she became a fulltime CFD day trader for more than 10 years. She now combines her passions for writing and trading at MarketMates. Join the blog to get the latest articles from Cate.
Cate Cook

Cate Cook

Cate is a journalist by profession who started trading shares in 2008, after which she became a fulltime CFD day trader for more than 10 years. She now combines her passions for writing and trading at MarketMates. Join the blog to get the latest articles from Cate.

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© 2024 – MarketMates.
All rights reserved | Privacy Policy | Risk Disclosure

General Advice Warning: From time to time, you may receive general non-binding advice from us. This information is intended to be general and is not personal financial product advice. It does not take into account your objectives, financial situation, or needs. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant financial product having regard to your objectives, financial situation, and needs. MarketMates is not liable for or held responsible for any loss, financial or otherwise in relation to information received from MarketMates.

© 2024 – MarketMates.
All rights reserved | Privacy Policy | Risk Disclosure

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