What is Overbought and Oversold?
Overbought describes a security that has risen too far too fast and may be due for a pullback. Oversold describes a security that has fallen too far too fast and may be due for a bounce.
Overbought and Oversold Explained
These conditions are typically identified using oscillators like RSI or Stochastic. Overbought is generally above 70 on RSI, oversold below 30. However, in strong trends, securities can remain overbought or oversold for extended periods. The key mistake traders make is automatically selling overbought or buying oversold — these are warnings, not commands.
Real-World Example
During a strong earnings-fueled rally, a stock's RSI stays above 80 for five consecutive days. Traders who shorted on day one because it was 'overbought' suffered significant losses. The disciplined approach is to wait for the indicator to turn, not just reach an extreme.
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