When an asset reaches an overbought level, it means extreme price movement upside from where the reversal is highly expected. Conversely, the oversold level indicates a possible reversal point after an extreme bearish pressure in the price.
In any case, if you find extreme bullish or bearish price movements on an asset, it’s a signal for you to exit the market. However, traders often become confused when attempting to differentiate the overbought and oversold signals that may affect their trading results.
In the following sections, we’ll be discussing the core difference between overbought and oversold conditions, including their best use.
What Are Overbought and Oversold?
Overbought and oversold describes the price of an asset correlated to its intrinsic value. This leads to signals representing the market conditions determined by the news, earnings reports, events, and trends revolving around them. For example, the recent Bitcoin plunged based on Elon Musk’s tweet.
When an asset is overbought, it means the price is in bullish momentum for an extended period. Therefore, it’s trading at a higher price than its inherent value. As a result, traders will come to a consensus that the asset is overly expensive, which indicates a sell-off is about to happen. Hence, a reversal and pullback are imminent and the asset’s price will drop.
An oversold market indicates that an asset is trading below what it is worth at its current price. This happens when the asset is sold at an undervalued price over an extended period, signaling that it is already at its all-time low. As opposed to an overbought market, an oversold market often leads to an upward-direction rally, causing the asset’s price to surge.
How It Works: Overbought vs. Oversold
The price in the cryptocurrency market zig-zags, where there is a bearish correction after a bullish trend and a bullish correction after a bearish trend. Therefore, the core part of price analysis identifies the shift of the current trend, which is an extreme price reversal point.
Therefore, the overbought and oversold levels work like a rubber band in the financial market.
If you expand the rubber band and then let go, it will return to its normal position. The speed with which it does so depends on how much you’ve stretched it. The more you stretch, the quicker it will snap back to its original position.
Similarly, in the financial market, when the current trend moves to the overbought or oversold zone, the price has a greater possibility of returning to the equilibrium zone.
Let’s have a look at a practical example of overbought price:
The above image shows that the price is moving higher with a strong bullish pressure without correction, which indicates an overbought price.
Now, let’s have a look at an example of oversold price:
Here we can see that the price is moving lower with a strong bearish pressure, with no correction, which indicates an oversold price.
How To Identify If a Market Is Oversold and Overbought
In the above section, we’ve seen that continuous movement toward the downside or upside is considered as oversold or overbought price, respectively.
But how do you identify the level from which the reversal may happen? Does it require overbought or oversold indicators?
First, we can spot an overbought or oversold level just by watching the naked chart. The idea is that when the price moves up and reaches a significant resistance, it will be driven down and, with support, it will rise gradually, as shown in the image below:
However, this method has one drawback: we don’t know whether the price will reverse from the horizontal level or not. Therefore, traders use technical indicators, such as oscillators, to increase the probability of spotting an overbought or oversold market.
RSI Indicator Readings and Ranges
The Relative Strength Index (RSI) is the most popular and widely used overbought/oversold indicator for technical analysis among oscillators. The RSI indicator shows the possible overbought and oversold zone in a separate window below the main price chart.
Generally, the RSI value moves between the level of 0 and 100.
The RSI overbought oversold readings are as follow:
- A level above 70 is considered an overbought reading.
- At levels below 30, prices are considered to be in oversold territory.
At first, traders should find the overbought or oversold readings from the chart, and then confirm it with the RSI readings.
The example above shows that the price of Bitcoin has moved to the resistance level, while the RSI indicator has moved above 70. As both of these indicator readings point to an overbought level, the price moves down with intense selling pressure.
The stochastic oscillator is similar to the RSI indicator but uses 80 and 20 as overbought or oversold levels instead of 70 and 30.
As with RSI, the stochastic oscillator also moves between 0 and 100. When its reading reaches above 80 under 20 levels, that’s the time to wait for the price reversal.
Let’s have a look at how to identify the overbought level using the stochastic oscillator:
Here, we can see that the oversold price has moved down to the horizontal support level. In the meantime, the stochastic oscillator has moved below the 20 levels. As a result, the price has moved up as buyers become active from the oversold area.
Is RSI Reading Better Than MACD?
The relative strength index and moving average convergence divergence (MACD) both work as overbought/oversold indicators to define a price reversal point. However, the RSI indicator does indeed show a more reliable result than MACD.
Based on statistical data, RSI delivers a higher success rate, with fewer false signals than MACD. On the other hand, MACD works well in specific trading scenarios related to it. Other factors keep RSI outpacing MACD.
These factors are as follows:
- MACD works well in the trending market, providing less accurate signals in corrective or choppy markets, where RSI provides better results.
- In terms of signal numbers, RSI provides fewer signals than MACD — yet the strength of RSI indication remains strong.
- Moreover, RSI works better for Fundamental analysis is an approach used by cryptocurrency investors to establish the intrinsic value of a crypto asset.... than MACD.
- In the cryptocurrency market, it’s better to use RSI than MACD in order to decrease the number of trades and increase accuracy.
The above image shows how MACD provides false signals, while there is no false signal in RSI.
How Reliable Are Overbought and Oversold Levels?
In financial market trading, we use technical analysis to anticipate price movement based on past price data. As we trade on probabilities, we want to focus on increasing our odds of success as much as possible.
When we consider overbought and oversold levels, our main aim is to include these levels in our trading strategy and increase the chances of making consistent profits. However, if you try to rely on the stochastic indicator or the RSI signals in isolation, there is a higher possibility that you will lose money.
So, what is the best use of the oscillators?
The best technique is to use oscillators in tandem as a secondary confirmation alongside price action analysis.
For example, if you’re a price action trader, you probably identify the market trend and only trade when the price moves up from the support level within a bullish trend.
In that case, if the price moves up from the support level — and at the same time, RSI moves above 30 — then you can consider the bullish possibility as strong.
When you consider the reliability of the overbought and oversold level, these can easily become part of a trading strategy. However, you have to use other technical tools to achieve your financial goals. Most momentum indicators work well when prices are moving within a trend. But the ultimate tool you can add to your trading arsenal is always the price.
How To Trade With Overbought and Oversold Levels
Trading in the financial market requires a practical approach to making money, using tools like overbought and oversold levels. If you can aggregate your knowledge and convert all of it into an overbought and oversold strategy, then you’re ready to make money from trading.
Let’s have a look at a profitable trading strategy using the overbought and oversold levels.
Technical Indicators Used
- Exponential Moving Average (EMA) — value 20
- Simple Moving Average (SMA) — value 200
- Stochastic Oscillator
How to Make a Buy/Sell Trade
- If the price is trading above SMA 200, we can say that the long-term trend is bullish. Similarly, if the price is trading below SMA 200, the long-term trend will be bearish.
- The 20 EMA should be above the 200 SMA for the buy, and below the 200 SMA for the sell.
- To make a buy trade, find the price below the 20 EMA but above the 200 SMA, and wait for the stochastic oscillator to move up from 20.
- Conversely, to make a sell trade, ensure that the price is below the 200 SMA and the stochastic oscillator has moved down from 80.
Example Case Scenario
Let’s have a look at how to make a buy trade from the oversold level:
In the above image, the overall market trend is bullish where the price has moved below the 20 EMA, indicating short-term selling pressure. As the overall market is bullish, the price moves up as soon as a candle closes, after the stochastic indicator moves above 20.
Now, we’ll outline the bearish case scenario and how to initiate a selling position.
In the above image, the overall market trend is bearish, where the price has moved above the 20 EMA, indicating short-term buying pressure.
As the overall market is bearish, the price moves down as soon as a bearish candle closes after the stochastic oscillator has moved below 80. The stop-loss level is above the recent swing high, and take profit is based on near-term important support level.
Let’s summarize what we’ve learned about overbought and oversold signals:
- Overbought and oversold level work as a significant price zone, from which a reversal may happen.
- These levels are applicable in any financial market including forex, stocks, cryptocurrencies and indices.
- The overbought and oversold levels are identifiable using technical analysis: looking at the chart, and using indicators.
- Two popular overbought and oversold indicators are RSI and the stochastic oscillator.