Overbought vs Oversold Stocks: Key Differences and Examples FinancialContent

The opposite of overbought is oversold, where a security is thought to be trading below its intrinsic value. Relative Strength Index (RSI) This indicator determines the strength of a stock on a scale of 0 to 100. The values above 70 are considered as overbought and values below 30 as oversold. An asset is considered overbought when its price has risen significantly in a short amount of time and may be due for a correction or pullback. Overbought doesn’t mean the price must drop, it just means bullish momentum could be running out of steam. This information has been prepared by IG, a trading name of IG Markets Limited.

Remember: indicators guide probabilities, not certainties.

RS represents the ratio of average upward movement to downward movement over a specified period of time. A high RSI, generally above 70, signals traders that a stock may be overbought and that the market should correct with downward pressure in the near term. Many traders use pricing channels like Bollinger Bands to confirm the signal that the RSI generates. On a chart, Bollinger Bands lie one standard deviation above and below the exponential moving average of a stock’s recent price. Analysts that identify a stock with a high RSI and a price that is edging toward the high end of its upper Bollinger Band will likely consider it to be overbought.

Common Mistakes When Trading Overbought and Oversold Signals

Stocks often enter overbought or oversold territory during volatile periods like the Great Recession or the 2020 COVID crash. In fact, the same stock can waver from overbought to oversold in a relatively brief period when markets are uncertain. Overbought and oversold stocks are characterized by steep and abrupt price movements, with significant gains or losses occurring in brief periods. The charts of these stocks are easy to identify; the price action is practically vertical, and the volume is mostly going in one direction.

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It’s up to the individual trader to stay alert to what’s happening and decide what it means to their trading strategy. One use of an overbought or oversold indicator is to provide a potential signal to step aside rather than chase prices at an increasingly less-favorable risk-reward ratio. When people say a market is overbought or oversold, they usually mean a certain technical indicator has reached an extreme level. The most popular of these indicators—the Relative Strength Index (RSI) and the stochastic oscillator—gauge momentum. They measure how far and how fast the price of a security or index has moved in relation to its own recent prices. Therefore, overbought and oversold indicators can generate trade entry signals for traders who are looking for trend changes.

These conditions can persist longer than expected, particularly in strongly trending markets. However, it is essential for traders to remember that overbought and oversold conditions are not definitive indicators of price reversals. These conditions can persist for extended periods, especially in strong trending markets. As such, traders should use these conditions in conjunction with other forms of analysis to make well-rounded and informed decisions.

This infographic lays out the standard “danger zones” for both indicators. On the other hand, the Stochastic Oscillator couldn’t care less about how fast the price is moving. Instead, it measures where a security’s last closing price sits in relation to its high-low range over a certain period.

• Real confirmation comes from building a case for the trade by seeing if other technical factors agree with the signal.
• Some traders use pricing channels like Bollinger Bands to spot overbought areas.
• A stock is considered overbought when its price has risen rapidly and above its underlying value, which potentially makes it overvalued.
• These indicators allow traders to assess whether a price movement has gone too far in one direction.
• Value investors saw those figures and decided Tesla (TSLA) stock was oversold.

RSI > 70 = overbought condition, not an automatic sell.

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

What RSI Really Says (and What It Doesn’t)

If the market identifies an asset as oversold, it may signal a good time to buy. Conversely, when an asset is overbought, it may be a good time to sell. Oscillators are used to identify when the market is overbought/oversold. It lets traders know that an asset is trading in the lower portion of its recent price range or is trading at a lower fundamental ratio than it typically does.

Stocks that are overbought or oversold are ones that analysts believe are not trading at their real value. An oversold stock may be worth more than its present trading price, whilst an overbought stock may be selling for more than it is worth. There is a quick tool traders can use to gauge overbought and oversold levels, the Relative Strength Index (RSI).

The Stochastic Oscillator, being much more sensitive to the latest price action, will throw out signals far more often. You’ll see its line dart from overbought to oversold and back again more frequently, even on minor price wiggles. They both show up as oscillators on a scale, but they get to their conclusions in fundamentally different ways. Nailing down how they’re calculated is the key to knowing which one to pull out of the toolbox and when. For a more nuanced—and often more powerful—signal, you need to learn how to spot divergence.

Typically, an overbought market is the result of a bullish sentiment where investors are optimistic about the asset’s future prospects. This can lead to buying frenzies, where the fear of missing out (FOMO) drives prices higher, even though the asset may no longer reflect its true value. Other indicators used to assess overbought conditions include the Moving Average Convergence Divergence (MACD) and Bollinger Bands.

A stock is considered overbought when its price has risen rapidly and above its underlying value, which potentially makes it overvalued. It’s oversold when the price has fallen sharply and below its underlying value, which makes it undervalued. These conditions can signal that a price reversal may be coming, though they don’t guarantee it. Technical indicators are tools that use historical price and volume data to measure things like price momentum and trend strength.

• Without a stop-loss, a single trade where a “screaming buy” signal just keeps getting more and more oversold can blow a huge hole in your account.
• It’s best to consider “overbought” and “oversold” readings as warnings that a strong move is underway and that the music could stop (or not!) at any time.
• Introduction Contracts for Difference (CFDs) provide traders with a way to speculate on the price…
• A falling ADX that’s still at, say, 45, could mean the trend, though weakening, remains strong and the move could still have legs.

So when considering P/E, investors look not so much at absolute numbers as at historical ranges for a company, sector, or index. Many short-term traders look little—if at all—at fundamentals, as their systems are usually based on technical analysis. But fundamental readings of overbought and oversold can be useful for equity investors looking for an entry point or considering where and when to take profits.

Buying pressure can increase, leading to continued bullishness beyond reasonable levels for many traders. In such cases, traders call the asset overbought and often predict a price reversal. As measured by technical indicators, markets can stay at overbought or oversold levels for days or weeks.

For example, their credibility is enhanced when they converge with a bearish pattern after an overbought signal. Contrarian investors, seeking buying opportunities, find an oversold stock appealing due to their perception that the selling pressure exceeds rational valuation metrics. Such conditions typically prove temporary; thus suggesting a potential rebound as soon as market participants ease this intense and recognize the under-valued state of said stocks.

They are just one piece of the puzzle in determining the overall market trend. Traders should also consider other factors, such as the overall market trend, support and resistance levels, and fundamental analysis, to make more informed decisions. For instance, when an asset is overbought, traders may look for signs of a reversal or a pullback and consider selling or shorting the asset. On the other hand, when an asset is oversold, traders may look for potential buying opportunities, expecting that the asset will overbought vs oversold rebound to more reasonable price levels.