Oversold vs Overbought: Stock Market Explanation

What are oversold and overbought socks? How do determine overbought and oversold levels in the market? And what indicators to use? If you are looking for the answers to these questions, here is our mini Oversold vs overbought guide for beginner investors.

Oversold vs overbought explained

Having a good grasp of overbought and oversold conditions is essential for traders in financial markets. These terms refer to when the price of an asset has moved too much in one direction.

How to determine if an asset is oversold or overbought in the market?

Market conditions and moving averages are factors that can help identify when a stock is overbought or oversold. 

If a market is oversold, it could be a signal to buy if other indicators show a potential turnaround. On the other hand, if stocks are overbought, it could be a signal to sell.

Tools like the Relative Strength Index (RSI) and stochastics are used in technical analysis to spot these conditions. The RSI measures the strength and speed of price movements, with values ranging from 0 to 100. RSI levels can signal whether a market is overbought or oversold.

When the RSI rises above 70, it indicates an overbought condition, suggesting that the stock price may soon decrease. 

Conversely, when the RSI falls below 30, it suggests an oversold condition, hinting that the stock price could go up. Traders use these signals to predict changes in trends and adjust their trading strategies accordingly.

What is an overbought asset in the market?

Overbought occurs when demand for an asset drives its price to levels well above its intrinsic value.

Determining when an asset is considered overbought is highly subjective. However, we can note that an asset which experiences sudden increases over a very short period tends to be overbought. How to spot this situation in the market ?

Overbought situations are highlighted through the use of speed indicators. Indeed, fans of technical analysis use indicators such as the RSI or stochastic to identify overbought securities.

From a technical perspective, the term “overbought” describes a situation in which the price of a security has increased so much (usually by large volumes) that the oscillator has reached its upper limit. This can then mean that the price of the asset is overvalued and could experience a pullback.

What is an oversold asset in the market?

An oversold market situation occurs when the price of an underlying asset has fallen below its intrinsic value. This condition is often the result of market overreaction or panic selling.

Assets that have experienced significant declines over a short period of time are often perceived to have been oversold. Determining the degree of oversold of an asset is a difficult and very subjective exercise.

From a technical analysis perspective, this is a situation where the price of an asset has fallen so much that the oscillator has reached its lower bound. 

This is generally seen as a buying signal.The price of the asset is devalued and therefore there is a buying opportunity.

Thus, the main role of many technical indicators, such as the RSI, the stochastic or the MACD, is to identify areas where the price of an underlying has been pulled to an extremely low level.

RSI overbought vs oversold 

Have you ever heard in an analysis, an analyst advises this or that stock to sell since it was overbought and on the contrary to buy since it was oversold.

Where is that friend who tells you you have to buy it because it has already fallen significantly. And now that it is oversold it can only go back up? It seems like a self-fulfilling prophecy. 

What is oversold must go up and what is overbought must go down. Investors determine these overbought and oversold zones, particularly on the RSI and the stochastic.

The stock is overbought as soon as we exceed the level of 70. Oversold below 30. The RSI is therefore an indicator of trend strength. 

RSI trigger lines

However, we must twist the preconceived idea that an overbought stock will inevitably turn downward and vice versa. On the contrary, stocks can continue to rise despite being overbought. 

This proves the strength of the upward movement and we might as well avoid going against the trend in such strong movements. Periods of overbought and oversold may take longer to turn around than it does for you to remain solvent.

So avoid falling into this pitfall. That of believing that what falls will rise again and that what rises will fall. Analyze and take a position on rational decisions and facts and not on hypotheses with low probabilities.

The relative strength index provides short-term buy signals  and sell signals. Low RSI levels (below 30) generate buy signals. High levels, above 70 generate sell signals.

Investors can also use other trigger lines. By doing so, they can examine the market trend in general. For example, if the stock market is in a bull market with rising prices, then 40 can be used as the lower limit and 90 as the upper limit. 

Only if the indicator goes beyond that will it give a signal. Conversely, in a bear market where prices are falling over a longer period of time, trigger lines of 20 and 60 can be used.

Bottom Line

By using tools like the RSI and Stochastics, traders can better understand short-term price movements and create successful trading strategies. Recognizing when a stock is overbought or oversold allows traders to make smart decisions, manage risk, and take advantage of price changes and trend reversals.

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