Stocks tend to close near their highs in an uptrend and near lows in a downtrend. Therefore, price action that moves further from these extremes toward the middle of the range is interpreted as an exhaustion of trend momentum. Traders can consider implementing stop-loss orders to limit potential losses if the price continues to rise despite overbought conditions.

Generally, an RSI value above 70 indicates that a security is becoming overbought and may be primed for a oversold vs overbought price pullback. Conversely, an RSI below 30 suggests that a security is oversold and might be ready for a price bounce. Bear in mind that when the trend reverses, the first few periods show a slow movement of the indicator (the dots are very dense).

1. In May 2022, NRG Energy Inc. (NRG) is trading at $46.67 and has an RSI of 72.76; thus, it is a signal for stockholders to sell NRG stocks.
2. Identifying overbought and oversold levels is a key part of trading shares, commodities and a range of other markets.
3. Therefore, overbought or oversold signals from RSI or stochastics can sometimes prove premature in strong trending markets.
4. Recent volatility in the stock market that caused short-term price extremes has made it important for investors to understand the difference between overbought and oversold.
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6. These two conditions differ fundamentally in their market sentiment and implied potential actions.

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1. Actually determining the degree in which an asset is overbought is very subjective and can differ between investors.
2. An overbought market is the polar opposite, the stock price is about to decline.
3. The bigger the distance between the individual dots is, the more likely it is for quick, decisive price movements (overbought and oversold zones).
4. You buy a stock when it has been oversold because it is undervalued and the stock will rally on a price bounce.
5. It then drops below it for a while and then surges back above without crossing the overbought threshold.
6. Bear in mind that overbought and oversold markets can last for an extended period.
7. In other words, you should not use overbought and oversold concepts singularly.

You can also pair it with the Parabolic SAR to confirm precise entry and exit points. In the image below we see an example of an RSI reading above 70, where the market reversed shortly thereafter. Due to current legal and regulatory requirements, United States citizens or residents are currently unable to open a trading business with us. For example, if a company making $20 million per year has a market capitalization of more than $5 billion, it can be said to be overvalued. An oversold bounce in the Nasdaq 100 is poised to develop following a 15% decline. A key support area for the tech-heavy index is 14,400—a natural slot for an oversold bounce to unfold.

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In an uptrend, there are more gains, keeping the RSI at higher levels. In a downtrend, on the other hand, the RSI tends to stay at lower levels. PYPL shares skyrocketed during the COVID market recovery, bouncing from a low of $85 in March 2020 to $300 by February 2021. During the parabolic upward move, the RSI triggered an overbought signal twice, first in mid-2020 and again in early 2021. The signs of an undervalued stock include a P/B ratio lower than 1, a relative strength index (RSI) of 30 and below, and a stochastic oscillator of 20 points or less. However, traders should be cautious and seek confirmation from other indicators or news events before making a decision.

In that sense, you could say that overbought levels usually don’t work that well. Another trading indicator that’s often used to define overbought levels, is the Bollinger bands indicator. In short, it consists of a moving average, around which an upper and a lower band is drawn.

Overbought vs oversold levels

As their names suggest, to determine the instrument’s reasonable price, the former relies on fundamental indicators and industry factors. There are various technical indicators that can be used to identify overbought and oversold levels, but some are more effective than others. The two most popular indicators for charting overbought and oversold conditions are the relative strength index (RSI) and stochastic oscillator.

On the other hand, oversold conditions warn about growing buying pressure and the presence of a significant bullish sentiment. 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. This momentum oscillator helps identify overbought and oversold markets by comparing the instrument’s current price fluctuations to the historical ones.

When this is the case, traders refer to the asset as overbought and many will bet on a reversal in price. While they can precede price drops, securities can remain overbought for a while before a reversal occurs. Overbought conditions should be used as a warning signal, and traders should seek confirmation from other indicators or news events before deciding to sell. While RSI is a valuable tool for identifying overbought and oversold stocks, it is always beneficial to consider other technical indicators to complement your analysis. Overbought markets signal increased selling pressure and dominant bearish sentiment.

Monitoring overbought and oversold conditions can also aid in balancing and managing a portfolio. For example, in an overbought market, investors might consider taking profits on some positions or looking for opportunities in other, less overbought market segments. Those listed in our article should be enough to ensure the adequate and timely identification of overbought and oversold markets. 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.

If the price of an asset is moving down very quickly and then starts to consolidate, this could be an indication that it is oversold. Keeping an eye on a digital asset’s price action can also be a good way to identify overbought signals promptly. For example, if the price of a security is moving up very quickly and then starts to consolidate, this could be an indication that it is overbought.

Timing of Market Entry and Exit

At 30, an immediate reversal of the trend is anticipated—the price will bounce owing to market corrections. Understanding overbought and oversold stocks, along with the indicators used to identify them, can help traders spot potential market opportunities. While these conditions may signal a reversal, it’s important to recognise there is no one best overbought and oversold indicator and use multiple tools for confirmation. Open an FXOpen account today to access more than 700 markets, including a huge range of stock CFDs, and four advanced trading platforms.

Some ETPs carry additional risks depending on how they’re structured, investors should ensure they familiarise themselves with the differences before investing. Once the indicator leaves this range, the market is considered either overbought (when above +100) or oversold (when below -100). Oversold, on the other hand, is when the price of an underlying asset has fallen sharply, and to a level below where its true value resides.

The share market has witnessed volatility in 2021 as well; S&P 500 declined by 5% and ended at a 27% gain. IG International Limited is licensed to conduct investment business and digital asset business by the Bermuda Monetary Authority. The Japanese yen remains under pressure, trading near a five-month low against the US dollar. This trend is primarily driven by differences in monetary policy approaches. For example, if the RSI isn’t able to reach 70 on a number of consecutive price swings during an uptrend, but then drops below 30, the trend has weakened and could be reversing lower.