As a trader, being able to identify overbought and oversold conditions in a market can help you decide when to enter and exit a trade, what position to take, and when a trend reversal may be imminent. This insight allows you to manage risk and make more informed trading decisions.

The most common indicators used to identify overbought and oversold conditions are the Relative Strength Index (RSI) and the Stochastic Oscillator. Both tools are momentum indicators and are plotted on a separate chart adjacent to the price action chart. They are also banded oscillators and, therefore, have a specific graphic range between 0-100. Overbought and oversold readings define the upper and lower bands, or extremes, of that range.

Use the Stochastic indicator to identify overbought and oversold conditions

On a stochastic chart, readings that fall within the range of 80-100 are considered overbought, and readings that fall between 0-20 are considered oversold. The analytical concept of support and resistance dictates that when the price reaches an extreme overbought or oversold threshold, it will reverse. For this reason, random overbought readings are interpreted as bearish (sell) signals because price momentum is expected to move in the opposite direction. Conversely, oversold readings are considered bullish (buy) signals, anticipating rising price momentum.

However, a reading above 80 or below 20 does not necessarily constitute a call to enter a trade. In some cases, an asset may remain overbought or oversold for an extended period of time if the price trend remains strong (i.e. the price continues to close at its highs or lows). In the image below, the stochastic oscillator moves above 80 (producing a sell signal), but the price continues to rise - and the asset remains within the overbought range for a few days. If the trader entered a short position when the initial oscillator moved above 80, he would have ended up taking a loss or exiting the trade before the trend reversed in his favor.

Entering a strong trend will limit the amount of risk you take and protect you from entering a trade too early. Before acting on overbought and oversold readings, examine the price action chart and use a trend indicator such as Moving Average Convergence/Divergence (MACD) to confirm the direction and strength of the current trend.

To further validate buy and sell signals generated by overbought and oversold stochastic readings, traders also look for divergences and intersections of signal lines. Divergence occurs when the action price reaches a new high or low and the stochastic oscillator fails to follow it. Typically, divergence precedes a trend reversal because price momentum (as measured by a stochastic oscillator) is known to change direction before the price itself. For example, in the image below, the price is making a new low, but the stochastic oscillator fails to make a lower low than the previous readings.

At the point of this divergence, the two random signal lines intersect – another indicator that the trend is poised for a reversal. Before entering a long position, the trader must wait for confirmation of the corresponding change in price. Immediately after the divergence, the price fails to make a lower low and continues to rise in the opposite direction, thus confirming the reversal.

Use the RSI to identify overbought and oversold conditions

Unlike a stochastic oscillator, the RSI does not use a simple moving average as a second signal line and therefore cannot be used to identify a crossover. Although the RSI uses a different analytical formula, it also measures price momentum and is used to determine overbought and oversold readings. Although the stochastic oscillator and the RSI have the same chart range, RSI readings above 70 are generally considered overbought, and readings below 30 are considered oversold (as opposed to 80 and 20 on the stochastic oscillator).

When the RSI rises above 70 and then falls back below this oversold threshold, it is believed to indicate that the trend will reverse and the price will fall. Under this hypothesis, the movement of the RSI is seen as bearish. Likewise, when the RSI falls below 30 and then crosses back above the 30 line, it is understood as bullish, anticipating a corresponding rise in price.

As with the Stochastic indicator, RSI buy and sell signals should always be evaluated in the context of the current trend in order to minimize risk. For example, if the price is forming a strong uptrend, the trader should ignore oversold readings that oppose the current trend until he can confirm the corresponding reversal. Although it is possible to profit by acting on overbought and oversold readings that challenge the overall market trend, this strategy requires traders to make quick entries and exits and, ultimately, means taking on more risk for less potential reward.

Failure volatility is also used to help identify price trend reversals. When the RSI rises above 70, falls below 70, and then rises again without crossing the overbought threshold, it is considered a failed swing. The same is true when the RSI falls below 30, rises above 30, and then falls again without crossing the oversold line.