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Overbought & Oversold

Technical Analysis

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Buying and Selling can eventually push prices to extreme conditions known as overbought and oversold. An “overbought” asset has been purchased to an upper extreme. The price now exceeds what demand is willing to pay, and supply is extremely willing to make sales at the higher price. A reversal is likely to occur as a result, and price will begin a downwards trend.

“Oversold” is similar, but in the opposite direction. Strong selling from the supply side pushes prices down to a lower extreme, and price is now lower than what new sellers are willing to receive for the asset. If buy side traders believe they are getting a strong deal on securities and should begin purchasing large amounts of assets, they will, halting the price decline and may initiate an upward price trend.

Many Technical Indicators attempt to show overbought and oversold levels. These include Oscillators like the Relative Strength Index and Stochastics. It’s important to note that these indicators do not necessarily you a reversal is highly likely, as price can continue to trend in an overbought or oversold zone. Additionally, it can pull back out of an overbought or oversold zone, then continue trending in the same direction. An exit from an overbought or oversold zone alone does not confirm a reversal, but it is one signal that used in combination with other signals can confirm or indicate a change in the trend.

Utilize Oscillators with overbought or oversold zones with other signs. These include reversal price patterns, reversal candle patterns, reversal crossovers in other indicators, and divergences. The combination of these things can confirm a reversal when they occur in tandem with each other.

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