Last Updated on April 5, 2021
The oldest principle in trading and investing is to buy low and sell high. The best way to do that is by finding opportunities trading at levels below their intrinsic or fair value. Alternatively, you can find discrepancies and seize the moment right before a price correction. To capitalize on these opportunities, traders rely on indicators that help them identify overbought and oversold markets. This guide explores the topic in detail. We will present you with a list of technical trading tools you can use and some tips on spotting these markets. Hopefully, by the time you finish reading, you’ll also learn how to profit from overbought and oversold markets.
What are Overbought and Oversold Markets?
We use the terms overbought and oversold to describe an asset’s price relative to its fair or intrinsic value. They help define current market conditions and future trends to help us identify buy and sell signals.
When we define an asset as “overbought,” it means its price has been going up consistently. As a consequence, it’s now trading at a higher price than what it is worth. As a result, its price has reached a tipping point, and we can expect it to drop soon. The pullback happens once traders unite around the idea that the asset is too expensive.
On the other hand, an oversold market is when the asset is trading below its fair value. As in, when it is worth more than its current price. Oversold markets usually appear when there has been a continuous selling of a particular instrument to a point where traders start thinking that its price has hit rock bottom. Oversold markets signal the end of short-term declines and the start of an upward rally.
Overbought and oversold levels signal that markets have matured and seen prices hit extremes. Market participants’ overreactions usually cause them. These may include increased buying or selling activity resulting from recent news, earnings releases, market-moving events, etc.
Based on the tools used to determine the overbought and oversold markets, there are two categories of market conditions. These two are fundamentally overbought/oversold and technically overbought/oversold. As their names suggest, to determine the instrument’s reasonable price, the former relies on fundamental indicators and industry factors. Meanwhile, the latter employs technical trading signals.
How Overbought and Oversold Markets Can Help You
Being able to recognize overbought and oversold markets is the cornerstone of a sound investment strategy. If you can identify overbought and oversold levels, you will guarantee that you are buying and selling at the best possible price.
Assets’ prices can’t move in one direction indefinitely, and, at some point, they will turn and embrace an opposite journey. Being able to time the moment right before this happens is what turns good into great traders.
The essence of strategies based on identifying overbought and oversold markets lies in their ability to predict when the expectation of the looming price drop/increase (correction) will materialize. These signals allow traders to buy at a lower price and sell at a higher one. Maximizing their returns this way helps them make the most out of the market opportunities.
While all this sounds great on paper, the truth is that identifying overbought and oversold markets might be a bit challenging for first-timers. Some traders spend years polishing and mastering their strategies, but it is well worth it in the end. The key to succeeding is employing them right.
Indicators to Identify Overbought and Oversold Markets
Bear in mind that overbought and oversold markets can last for an extended period. They will test your patience, and you should make sure to stick to your strategy and trade only when you are confident you have spotted the right signal. So, how to spot the right signal? The answer is – by relying on technical trading indicators.
Investors usually rely on fundamentals indicators like price-to-earnings to spot overbought and oversold markets. Traders employ technical indicators. The majority of the tools that help identify overbought and oversold markets fall under the “oscillators” category, but we will suggest other less known indicators but equally efficient.
Whether you are using an oscillator or another type of indicator, the common thing is that their purpose is to help you identify when a trend reversal is about to occur.
Stochastic Oscillator
This indicator is one of the most popular ones for identifying overbought and oversold markets.
When applied on a chart, we can visualize the indicator as a line with a value between 0 and 100. You can interpret the indicator’s value the following way:
- Oversold – between 0 and 20
- Overbought – between 80 and 100
So, what does this tell you? The overbought signal generated by the stochastic oscillator indicates a looming bearish market and a right moment to sell. On the other hand, the oversold signal warns you about an upcoming bullish price reversal, which is the right moment to buy.
However, bear in mind that the indicator can remain within the overbought or oversold zone for an extended time. The indicator can’t tell you when exactly the price reversal will take place. That is why it is essential to complement it with other technical trading tools and keep an eye on the price.
More specifically, look for divergences and signal line crosses. When there is a divergence (the price hits a new high/low, but the indicator doesn’t follow), you should expect a trend reversal to follow as the stochastic oscillator usually shifts direction before the price. Further confirmation is if the two lines cross.
Relative Strength Index (RSI)
The RSI is very similar to the Stochastic Oscillator in the context that it also measures price momentum to identify overbought and oversold markets. The main difference is that the RSI doesn’t rely on a simple moving average as a second line. Due to this, it is inefficient for spotting crossovers.
With the RSI, we consider markets where indicator floats above 70 overbought. Meanwhile, the ones below the 30 mark are oversold.
The general interpretation of the RSI’s signals is as follows:
- Sell when the indicator climbs above 70 and falls back below it.
- Buy when the indicator falls below 30 and rises back above it.
However, bear in mind that this isn’t a universal indicator that will work efficiently, ignoring the situation’s context. For example, if the price is forming a strong uptrend, it is better to ignore the oversold signals, opposing the current trend development until a corresponding reversal is confirmed.
When using the RSI, you should be aware that the indicator often generates failure swings. These are situations where the RSI surpasses the 70 point mark. It then drops below it for a while and then surges back above without crossing the overbought threshold. We can consider these developments strong confirmations of an upcoming trend reversal.
Bollinger Bands
Bollinger Bands are one of the simplest indicators to use when looking for overbought and oversold signals. The indicator is a pricing channel that consists of three lines, all of which use the 20-day SMA.
If the price breaks the upper line, then the signal is bearish, and the market is considered “overbought.” In that case, you can expect a downslide to take place, and it is a perfect moment to sell.
On the other hand, if the price breaks the lower line, then the market is oversold, and you should expect a bullish rally. This moment is usually the right one to buy.
Make sure to wait for a full candle, confirming the signal to close before opening a position. In the example above, you can see that, in the “overbought” scenario, the lines are broken with a bullish candle first. However, the price drop starts after a bearish candle closes. So is the case with the oversold scenario where the upside rally begins with the first bullish candle.
Commodity Channel Index (CCI)
This momentum oscillator helps identify overbought and oversold markets by comparing the instrument’s current price fluctuations to the historical ones. Don’t let the name of the indicator deceive you – you can apply it to all types of assets, including stocks, FX, and more.
The indicator’s initial idea was to reduce the uncertainty caused by cyclical and seasonal markets in commodities. Today, it is a great tool to help predict upcoming trend reversals.
On a chart, you can plot the indicator as a line within a box. The CCI fluctuates between values -100 and +100. Once the indicator leaves this range, the market is considered either overbought (when above +100) or oversold (when below -100).
When the price goes above +100 and then drops back below it, traders can sell in anticipation of a bearish trend. In contrast, when the indicator drops below -100 and then gets back above it, traders can buy as the bullish sentiment is considered intense.
However, it is essential to avoid trading the first time the indicator surpasses either of the levels. The reason is that, during strong trends, overbought and oversold conditions might persist for an extended period. Like the example with the Bollinger Bands, make sure to have a trend confirmation from the next candles.
Another crucial thing to know about the CCI is that the -100 and the +100 range aren’t immutable. The results can differ for each asset. Ensure you’re familiar with the historical values to get a fair representation of the exact reversal points before placing your trades.
Parabolic SAR
The Parabolic SAR isn’t a well-known tool for the purpose, but many advanced traders rely on it to spot overbought and oversold markets. However, bear in mind that it takes time to master the indicator’s signals, so if you are just starting, you should better stick with the RSI or the Stochastic Oscillator.
The Parabolic SAR indicator monitors price changes and the speed at which they occur to help identify overbought and oversold conditions. SAR in the name stands for “stop and reverse.” It has the word “parabolic” because the result of the indicator’s calculations collectively shapes a parabola.
Parabolic SAR is a preferred trading indicator because it reveals details about the market’s overall state and the pace with which price swings occur.
The indicator appears as a series of dots on a chart, standing next to the price bars. The indicator stands below the price during bullish trends, while during bearish periods, it remains above it.
The bigger the distance between the individual dots is, the more likely it is for quick, decisive price movements (overbought and oversold zones). When the dots get closer to each other, it is an indication that we might expect a slowdown in momentum.
Bear in mind that when the trend reverses, the first few periods show a slow movement of the indicator (the dots are very dense). As the trend develops, the indicator speeds up and catches up with the price.
Fibonacci Retracement
Fibonacci Retracement is among the most popular technical trading indicators. We can visualize these lines in the form of support and resistance levels. They can be instrumental when in need of overbought and oversold signals.
The indicator’s underlying concept is The Dow Theory of Retracement. According to it, once an initial price movement occurs, the price will eventually retrace with close to 50% (the middle between the Fibonacci retracement levels of 38.2% and 61.8%). According to this theory, the best moment to open a position is once an overbought or oversold signal is confirmed.
Using Fibonacci Retracement to identify overbought and oversold signals requires you to track whether a clear support/resistance line is present. If the price repeatedly fails to overcome the support/resistance line and finally does, you have a potential overbought/oversold signal.
Understandably, the Fibonacci Retracement on its own isn’t a very sound indicator for overbought and oversold signals. It is always better to combine it with other indicators, such as the Stochastic Oscillator, to confirm the relationship between the retracement and the current market conditions.
On-Balance Volume (OBV)
This momentum indicator uses volume flow to help traders identify overbought and oversold markets. It predicts bullish and bearish reversals by reflecting the crowd sentiment and measuring the buying and selling pressure.
The idea of the OBV is that a change in price will always follow an increase in trading volume, even if it doesn’t happen right away.
Using the indicator to identify overbought and oversold markets requires monitoring the price behavior and the OBV’s movement simultaneously. If the price marks higher highs while the OBV makes lower highs, it is a signal for an overbought market. You should expect a price reversal and a downward rally—this a perfect moment to sell.
Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence is another indicator capable of identifying overbought and oversold markets. By replicating the relationship between the 12-day and the 26-day exponential moving averages, the MACD plots a signal line that helps traders spot buy and sell signals.
To recognize overbought markets, traders look for when the MACD crosses below the signal line. That moment is a potential opportunity to buy since, at that point, the market is likely to move upward. On the other hand, if the MACD crosses below the signal line, then the market is considered “overbought,” and you can proceed to sell to avoid suffering capital losses due to the looming downward price movement.
However, bear in mind that MACD isn’t the most reliable indicator for overbought and oversold markets if used alone. Make sure to complement it with an additional tool like the Relative Strength Index or the Stochastic Oscillator so that you can better confirm the trend’s strength and spot divergences.
You can also pair it with the Parabolic SAR to confirm precise entry and exit points.
The Difference Between Overbought and Oversold Markets
While both indicate a potential upcoming price correction, the difference between overbought and oversold markets is in the direction of the expected reversal they signal. When the market is overbought, the price is likely to drop soon. When the market is oversold, we can typically expect the price to go up.
Overbought markets signal increased selling pressure and dominant bearish sentiment. On the other hand, oversold conditions warn about growing buying pressure and the presence of a significant bullish sentiment.
Overbought markets indicate that the particular asset’s price is higher than its intrinsic (fair) value, Meanwhile oversold markets signal that its current price is lower than what the security is worth.
What pushes the asset’s price to an “overbought level” is the increased demand that exceeds the natural and typically-common trading interest. As a result, the price rises to an unjustifiably high level without any support from the fundamentals or technical indicators. Alternatively, the price is artificially high.
With oversold markets, the asset has fallen to a level where it trades much cheaper than it is worth. Such situations are usually a result of panic selling or market overreaction.
The common thing between overbought and oversold markets is that, in both cases, analysts consider the instruments not trading for their true worth and look forward to a near-future correction.
Final Thoughts
The concept of overbought and oversold markets is crucial for traders to understand. At the same time, it is easy to understand and apply if you have the right tools.
Not all trading indicators are equally efficient. Those listed in our article should be enough to ensure the adequate and timely identification of overbought and oversold markets. Especially if you use the suggested technical tool combinations.
If you want to take your strategy to the next level, make sure to complement it with several technical trading indicators and even fundamentals to ensure a 360-degree view of the market.
