Overbought/Oversold Indicators

Overbought/oversold indicators are a category of technical analysis visual tools which allow traders of financial markets to identify potential peaks and troughs of a particular asset.

Overbought and oversold are actually very vague expressions. The term overbought refers to the point at which the price of an asset has been increasing continuously for a prolonged period of time without a reversal.

Of note, this also includes only minor retracements, to such an extent that a downwards reversal is due soon.

By extension, oversold refers to the point at which the price of an asset has been declining continuously for a prolonged period of time without a reversal.

This also indicates only minor retracements, to such an extent that an upwards reversal is due soon.

Thus, overbought/oversold indicators incorporate the notion that the price of an asset cannot continue in the same direction indefinitely.

What Can Overbought/Oversold Indicators Show Us?

Despite the relative ambiguity of the exact definition of the terms overbought and oversold, that didn’t stop mathematicians in developing indicators that attempt to pick out overbought and oversold zones.

These indicators in fact became so popular that today they are a staple of trading platforms since online trading began.

Indicators such as the Stochastic Oscillator, the Relative Strength Indicator (RSI), Williams’ Percent Range (WPR) the Commodity Channel Index (CCI) are just a few of the commonly used overbought/oversold indicators used by traders worldwide.

The Stochastic and the RSI both share similar overbought and oversold zones, with anything over 80 considered overbought and anything below 20 considered oversold for the Stochastic, and 70/30 for the RSI, with both of their maximum and minimum ranges fixed from 0 to 100.

Other oscillators like the CCI do not have a fixed minimum or maximum, while others can be placed directly overlying the candlesticks themselves.

This includes channel-based indicators, though all of them can be equally as useful.

Some overbought/oversold indicators are more widely used than others, but they all have their advantages and disadvantages.

The common disadvantage shared by all of them is something unavoidable, which is no single indicator alone can predict the turning point of the market.

What often happens is a price will remain in an overbought or oversold state for a long period of time, rendering any attempts at picking out reversals as fruitless.

However, when used together, a lot of the false signals are eliminated, giving the trader much more confidence in determining the end of a trend.