Overbought And Oversold Indicators

What Are Overbought And Oversold Indicators?

Overbought and oversold indicators are a form of technical analysis of stocks or any other form of securities, using charts, which guide the traders while making decisions regarding the selection of buy and sell points. These indicators reveal the actual market price as compared to their fair value.

A proper understanding of such indicators is crucial because they analyze the price levels with respect to a particular threshold through specific online tools that consider factors like volume, price fluctuations, and speed of change or momentum. They are mainly used for trading in stocks and are also applicable for derivatives, commodities, forex, etc. 

• Overbought and oversold indicators refer to technical analysis of securities using charts and online tools that help in identifying buy and sell points.
• Traders analyze them in order to understand the price movements and the strength of the security in the market.
• It gives a clear idea about the current market price in relation to fair value.
• It helps forecast the direction of the stock movement and understand its future trend, based on which traders can place their trades.

Overbought And Oversold Indicators Explained

The overbought and oversold indicators identify the price levels of securities in the market with respect to their fair market price by considering a particular level or threshold of the same in the charts. They act as psychological triggers and help traders evaluate and decide the entry and exit points.

In this context, it is necessary to understand what technical analysis is. It is the method of evaluating the stock performance in the market using charts and online tools that use current and historical data related to price and volume. In such charts, one can use various indicators that automatically provide a visual representation of the stock’s price movement, which guides traders while entering into trades, whether for buy or sell or for short or long term.

The most common and best overbought and oversold indicators used for this purpose are the Relative Strength Index (RSI), Stochastic Indicator, and various other price action indicators. The RSI is a momentum indicator that measures how fast price changes occur. The Stochastic indicators are similar to the former, but they compare the closing price to a particular price range taken over a certain period. The price action indicators include various candlestick patterns, like doji, morning star, evening star, head and shoulder, and many others. The article below elaborates on this for better understanding.

In this context, an overbought condition reflects the level at which the stock prices have greatly exceeded the fair price because it is in high demand among investors. At this level, there is every possibility that the price will come down in the future. Investors should be careful at this stage because there is not much chance for an upside at this level.

Similarly, an oversold position shows the opposite picture. The stock trade is much below its intrinsic value due to the very low demand in the market. Experienced traders identify such points where the price is at its lowest level and enter the market because now there is every possibility of an upside since there is not much room for the price to fall further.

Now, let us study the various indicators in detail to use them at appropriate levels to decide on trading positions.

Top Indicators

Here, the best overbought and oversold indicators are explained in detail.

#1 - Relative Strength Index (RSI) Indicator

The RSI is a momentum indicator that measures the magnitude of recent price changes. In other words, it assesses how fast the price movement is taking place and its strength or weakness. The traders can understand or make an idea about whether the current price levels are sustainable for the short or long term. One can measure the momentum on a scale from 0 to 100, and the formula used to measure the same is as follows:

RSI = 100 – (100/1+RS)

In the above formula, the RS is the Relative Strength and calculation happens based on the ratio of average gain to average loss during a specified period. The average gain is the upward movement, and the average loss is the downward movement. Typically, RSI considers the observation for 14 days, but it is possible to customized based on the trader’s requirements.

However, traders do not do such calculations manually because they are available in different technical analysis applications and websites. To identify the overbought and oversold levels, even though it is possible to customize it, a trader usually takes a level range of 30 to 70. If the graph goes below 30, it is oversold with a possibility of a rebound, which is a potential signal to buy the stock. Above 70 is considered overbought, with a possibility of a pullback or reversal downwards. This is a potential signal to sell the stock.

#2 - Stochastic Indicator

This is also a momentum indicator, similar to RSI. However, it compares a specific closing price with a range of prices during a certain period. However, the period is adjustable based on the trader's requirements. The indicator has two separate lines, the K(default setting – blue) and D(default setting – orange) lines. The D line is the moving average of the K line. The lines oscillate between 0 to 100, similar to RSI. The ideal range considered is 20 to 80 levels.

If the blue K line rises above the orange D line and the K line is above the 20 level in the chart, the trader can assume that it is an oversold position and the stock has the possibility of an uptrend from here. The trader at this level should decide on a buy position. Similarly, if the blue K line falls below the orange D line and the K line is below the 80 level in the chart, then it indicates a potential downtrend in the near future because of overbought conditions.  At this level, the trader should decide to sell off or take a short position.

#3 - Price Action Indicator

The price action indicators are commonly the various candlestick patterns that traders use and identify through charts. There are various types of such patterns, some of which are worth mentioning as given below:

• Doji – This candle has a tiny body because the opening and closing prices are very close to each other. It has a long shadow, also called a wick, which may be on the upper or the lower part of the candle. It shows that both bulls and bears are strong against each other, and the market is indecisive. It isn't easy to make trade decisions based on this indicator.
• Morning star – It is a pattern of three candles, formed at the bottom of a down move, where there is first a red bearish candle, then a doji, and after that, a big green bullish candle. It signifies an up move or the possibility of an uptrend in the near future, where the trader can buy. 
• Bullish Engulfing – In this, a prominent green bullish candle forms immediately after a red bearish candle, and the green one engulfs the red one. It is a good indicator of an uptrend and a point at which to enter the market.
• Head and Shoulder – It gives a sign of potential reversal of the trend going on currently, which can be an uptrend or a downtrend. It has three distinctly visible peaks, with the central peak or the head considerably higher than the two lower peaks on either side, which are the shoulders. It primarily signifies a shift in market sentiment from bullish to bearish, which is a reversal in trend. The traders try to identify the neckline, which is the line connecting the lowest points of the shoulders. Once the price falls below the neckline, it indicates a downtrend, a time to exit the market.

However, many such indicators for overbought and oversold are there to detect price action, like evening star, double top, double bottom, rounding bottom, and so on, which also help identify the buy and sell points.

Charts

The explanation is easy to understand practically with the help of some charts taken from TradingView, as given below.

#1 - Relative Strength Index (RSI) Indicator

As per the explanation provided above, a view of the same in a technical chart will give it more clarity.

Source

In the above chart, one can see Nifty. It is a daily chart of the index, and below the candlestick patterns, there is the RSI indicator in a blue line. It ranges between 30 and 70, and one can notice that the points of the RSI, where the oversold positions, are the ones that hit the 30 level. For almost all of them, the next movement is a down-move. Similarly, the overbought positions are the points that are close to the 70 level.

#2 - Stochastic Indicator

To explain this, here is a daily chart of Reliance Industries with the stochastic indicator where the blue K line and the orange D line are visible.

Source

When the K line rises above the D line and crosses the 70 level, it is in an overbought position, which is a downtrend signal. The time to exit the market and the points where the K line comes below the D line and falls below the 30 level signifies the oversold position, which is the time to enter the market.

#3 - Price Action Indicator

Candlesticks – Here are some candlestick patterns that is marked in a weekly chart of Reliance Industries. As per the explanation already given above for the same, it is possible to match each explanation with the pattern. 

Doji -

In the below chart of MothersonSumi, there is are doji candles formed, highlighted with red and green arrows. Clearly, it is an indecision candle, and everytime it appears, there is an upmove, downmove or sideways trend in the stock. A doji at resistence level is a strong indication that the market will go down and at support level it indicates an upmove. However, the stock may go sideways too due to doji, as shown above. Therefore, it is very hard to take trade decision based on this pattern.

Source

Morning Star -

The below daily chart of Cummins India, showing the morning star candlestick pattern. In the pattern, there is firstly a red bearish candle, followed by a doji and finally a green bullish candle. It has made a trend reversal upwards, which is the main significance of this pattern.

Source

Bullish Engulfing Pattern -

The bullish engulfing pattern, as shown in the Nifty chart above, is the big green candle that has totally engulfed the red bearish candle. It is an excellent indication of an uptrend, and that is what has precisely happened in the chart above.

Source

Head and Shoulder -

In the Asian Paints' hourly chart, the head and shoulder pattern is clearly visible.

Source

This pattern signifies a trend reversal upwards, which has actually happened in the chart above. The head and two shoulders are clearly visible and marked.

Examples

These examples will help us understand the concept of indicators for overbought and oversold.

Example #1

Suppose John is a short-term trader and thoroughly tracks the stock market to check and identify points of entry and exit to make some profits within a timespan of a few days to weeks. He is able to identify ABC Industries' stock, which is currently trading at the 30 level of the RSI indicator. He decided to enter the market by investing in this stock because it has good future growth potential and has recently come into the news as the upcoming new entrant in the electric vehicle market. Within the next two weeks, the price rises by 50%, and John makes a substantial profit and exits the market. Thus, RSI is an excellent indicator of overbought and oversold levels.

Example #2

As already explained, the overbought territory is the condition where the stock is in high demand, and investors buy it very frequently, pulling up the prices. In this context, the article explains this condition well from the point of view of the Nifty 500 index, where some 93 stocks were trading in this overbought position, leading to an anticipation of the creation of selling pressure and, thus, a down move. One can use the primary and widely used indicator, RSI, which is highly dependable in terms of estimating the overbought and oversold levels.

Importance

Here are some importance of the concept:

• These indicators are extremely useful in identifying the buy and sell points. Based on these indicators, the traders can decide on the entry and exit levels and take profitable trades.
• Such indicators give traders confidence about their decisions.
• They help minimize the risk of loss by entering or exiting the market at the correct levels. Entering at the correct level means buying stocks at the minimum price, after which there is a possible uptrend or rise in price, and selling at the highest level, after which there is a possible downmove or downtrend.
• Since traders can confidently invest using these indicators, it is possible to mobilize the funds in the stock market.
• Using these indicators, a trader can trade in various financial instruments, which ensures and encourages more and more investors to enter and participate in the financial market, ultimately benefitting the economy as a whole.

Frequently Asked Questions (FAQs)

Recommended Articles

This has been a guide to what are Overbought And Oversold Indicators. We explain the top indicators along with charts, examples, and importance. You may also find some useful articles here -

• Advanced Technical Analysis Course
• Support Line
• Bollinger Bands