Oversold and Overbought – Tools Every Trader Should Know

When you see asset prices continuously falling until you feel they are already cheap but keep dropping further, or when you see prices soaring and think “it must be inflated” but continue to rise, that’s the time you need to understand Oversold and Overbought conditions to avoid making poor trading decisions.

What are Oversold and Overbought, and Why Are They Important?

Oversold (overly sold) occurs when an asset has been sold down excessively beyond fair value, causing the price to fall below the probable level. Essentially, the market is lacking “buyers,” and once selling pressure diminishes, prices tend to rebound. This situation often signals a better opportunity to “buy.”

Overbought (overly bought) is the opposite scenario, where prices have been pushed above fair value due to excessive buying. When buying momentum wanes, selling often begins, leading to a price correction.

These two conditions do not necessarily indicate immediate change; they depend on context, time frame, and market conditions. However, they serve as warning signals that “the market may change direction.”

Indicators to Help Remember What Oversold/Overbought Means

RSI (Relative Strength Index) – a straightforward indicator

RSI measures the ratio between upward and downward price movements, calculated as:

RSI = 100 - (100 / (1 + RS))

where RS = average gains over 14 days / average losses over 14 days.

RSI ranges from 0 to 100, with:

• RSI > 70 = Overbought (overly bought) – indicates strong buying pressure, possibly a profit-taking point
• RSI < 30 = Oversold (overly sold) – heavy selling, possibly a buying opportunity

Caution: In strong uptrends, RSI can stay above 70 for extended periods, so thresholds should be adjusted based on asset behavior.

Stochastic Oscillator – another tool to measure Oversold/Overbought

Stochastic indicates where the closing price is within the high-low range over the past 14 days, calculated as:

%K = [(closing price – lowest 14 days) / (highest 14 days – lowest 14 days)] × 100

%D = 3-day moving average of %K

Thresholds:

• %K > 80 = Overbought – too much buying
• %K < 20 = Oversold – too much selling

Stochastic often provides slightly earlier signals than RSI but remains a helpful tool, not a definitive signal.

How to Use Oversold/Overbought in Actual Trading

1. Mean Reversion – Sell high, buy low

Mean Reversion assumes that Oversold or Overbought conditions are temporary and prices will revert to the “average” (MA).

Steps for Mean Reversion Trading:

1. Use MA200 to identify the primary trend – if price is above MA200 = uptrend; below = downtrend
2. Set RSI Overbought at 75 and Oversold at 35 (slightly above/below standard levels) to avoid false signals
3. When RSI enters Oversold in an uptrend → Buy at that point 4@ When RSI enters Overbought in a downtrend → Sell at that point 5@ Close position when price returns to MA25

Example USDJPY 2H:

• Price oscillates above MA200 )weak uptrend)
• RSI drops below 35 (Oversold zone) → buy signal
• Close when price returns to MA25

( 2. Divergence – Catching trend reversals

Divergence occurs when price and RSI give conflicting signals, such as:

• Price makes a new low )Lower Low### but RSI does not make a new low (higher low) = Bullish Divergence (possible upward move)
• Price makes a new high but RSI does not = Bearish Divergence (possible downward move)

Divergence is most reliable when combined with Oversold/Overbought conditions.

Steps for Trading Divergence:

1( Look for a clear trend )up or down) 2( Observe RSI + price divergence + Oversold/Overbought signals 3) Wait for confirmation )e.g., price breaks MA5) 4( Enter trade

Example WTI 2H:

• Price makes a new low )downtrend) → RSI enters Oversold
• But RSI does not make a new low; instead, it forms a Higher Low = Bullish Divergence
• Entry point: price breaks above MA25
• Stop loss: previous low

Warning: Oversold does not always mean “must buy”

• In a strong downtrend, prices can remain oversold for a long time and continue falling
• In a strong uptrend, prices can stay overbought for extended periods
• Always wait for confirmation signals (MA, Divergence, Pattern, etc.)

Summary

Oversold and Overbought are tools traders use to indicate that the market may be overextended or oversold, but they do not tell the direction alone. They should be combined with:

• Major trend (Trend)
• Moving averages (MA)
• Divergence
• Chart patterns

When used together, Oversold/Overbought become vital tools, not just signals to sell at the bottom or buy at the top, which many novice traders often mistake.