What does it mean that the market is oversold or overbought?

A trader needs to know how to read the market. This is one of the conditions to be on the path to success. It will help in identifying the best places to open and close the position, predicting reversals of the trend and managing risk.

You might hear the expression that the market is being overbought or oversold. What does it really mean? How to utilise such information in trading? Let’s see into this topic today.

Overbought and oversold markets

We say that the market is overbought when the price was rising for a time being and the asset is now trading at a higher price than its real worth. The price reaches extreme values and eventually, it will begin to fall.

The oversold market shows that the asset is trading below its fair value. It happens during a long downtrend. The price reaches extremely low levels and then it reverses.

Being able to determine when the market is being overbought or oversold can significantly improve your trading performance. The price is changing direction all the time. Knowing when it might happen will definitely help to enter or close the trade just at the right time.

Identifying overbought and oversold markets

The easiest way to identify when the market falls into overbought or oversold areas is to use the help of the indicators. The most popular ones that can serve this purpose are the Stochastic Oscillator and the Relative Strength Index. They both appear below the price chart, in separate windows. Both are ranging between 0 and 100 values and the overbought and oversold zones can be identified when the indicators’ lines reach the extremes.

Stochastic Oscillator as a way to determine the overbought and oversold areas

The Stochastic Oscillator reveals oversold readings when it drops below the 20 line and overbought when it rises above 80. When the readings indicate the asset is oversold, a signal to buy is received. When the asset is overbought, it gives a bearish (sell) signal.

Nonetheless, you should not rush into opening a trading position. It is not said how long the price will remain in the overbought or oversold zones. It can be a few minutes or a few days even. So if you open the trade the moment the Stochastic crosses the 20 or 80 lines, you will very probably lose money.

What you should do instead is to further analyse the movement of the price. You can search for divergence, which is usually a signal the price will reverse. The divergence takes place when there are new high or low extremes visible on the price graph but the Stochastic does not do the same. Another reversal signal is produced when the two lines of the Stochastic cross each other.

You can also use another indicator such as the MACD to confirm the strength and the direction of the existing trend.

Identifying the overbought and oversold areas with the RSI

The range of the RSI is the same, which is from 0 to 100, the readings of the overbought and oversold zones are, however, different. This is because the formula to calculate the RSI is different and there is no simple moving average used as a second line. So, when the indicator rises above the 70 line, the asset is considered to be overbought. When It falls below 30, the instrument is oversold.

Again, the price can move within the overbought or oversold areas for a longer period of time. When using the RSI, you should wait for the moment the indicator’s line is coming back to the middle. So, a signal to sell is produced when the RSI rises above 70 and then crosses this line on its way back down. Buy when the indicator drops below the 30 line and then climbs back above 30.

Be aware of the risk and analyse the context of the current trend. The RSI may sometimes form failure swings. It happens when the indicator falls below 30, then moves above it and then falls again without intersecting the 30 line. Or when the RSI rises over 70, then drops below it and next rises again but without going past the 70 line.

Summary

Being able to recognise the moments the market is being overbought or oversold is quite important for successful trading. Technical analysis tools are undeniably great help in this task.

The Relative Strength Index uses trending information and this makes it less reliable in volatile markets than the Stochastic Oscillator. However, for most currency pairs both indicators can be used effectively.

To minimise the risk trade in the direction of the trend and confirm the signal received.

With time, every task seems easier. Use demo account offered by most of the brokers to practice new skills.

Wish you great profits!