Overbought vs. Oversold Signals, How to Tell the Difference?

In stock, forex, cryptocurrency, and other trading markets, accurately capturing potential price turning points is crucial. Overbought and Oversold signals are the core tools used by technical analysts to predict the market’s short-term overheating or cooling state. They act like a “thermometer” for the market, helping traders identify potential reversal or adjustment opportunities. So, how do we determine overbought and oversold signals? The answer lies in the proficient use of a series of classic technical indicators.

Core Judgment Tools

Relative Strength Index (RSI)

Principle: RSI measures the relative ratio of price increases to decreases over a period of time, with a range of values between 0 and 100. Judgment Criteria:

• Overbought Signal: It is generally considered that when the RSI value is above 70, the market may be in an overbought state, indicating that upward momentum may be excessively consumed, with risks of a pullback or reversal. In very strong trends, the threshold can sometimes be raised to 80.
• Oversold Signal: It is generally considered that when the RSI value is below 30, the market may be in an oversold state, indicating that downward momentum may be excessively released, with opportunities for a rebound or reversal. In very weak trends, the threshold can sometimes be lowered to 20.
• Key Point: The duration of RSI in the overbought/oversold regions and divergence phenomena (price making new highs/lows while RSI does not) can provide stronger signals.

Stochastic Oscillator

Principle: The stochastic indicator focuses on the relative position of the current closing price within the price range (from the highest price to the lowest price) during a selected time period (such as 14 days). It consists of the %K line (fast line) and the %D line (slow line, usually a moving average of %K), with values ranging from 0 to 100. Judging criteria:

• Overbought signal: When the %K line or %D line is above 80, the market is considered to be potentially overbought.
• Oversold signal: When the %K line or %D line is below 20, the market is considered to be potentially oversold.
• Key points: The crossover of the %K line and %D line (such as when the %K crosses above the %D in the oversold zone is regarded as a buy signal) as well as divergence phenomena are equally important.

Bollinger Bands

Principle: Bollinger Bands consist of a middle line (usually a 20-day moving average) and two outer bands. The outer bands are calculated based on the standard deviation of prices, representing the dynamic range of price fluctuations. Determination Criteria:

• Overbought Signal (Potential): When the price touches or breaks above the upper band, it indicates that the price is at a relatively high level and may be in a short-term overbought condition.
• Oversold Signal (Potential): When the price touches or falls below the lower band, it indicates that the price is at a relatively low level and may be in a short-term oversold condition.
• Key Point: Touching the upper and lower bands of Bollinger Bands is not a direct buy or sell signal; it often needs to be combined with other indicators (e.g., whether the RSI is simultaneously overbought/oversold) or observing whether the price stabilizes outside the bands to determine strength. Bollinger Bands are more effective in trending markets.

Other Auxiliary Indicators:

• Commodity Channel Index (CCI): It is generally believed that a CCI above +100 implies Overbought, while below -100 implies Oversold.
• Williams %R: The value ranges from -0 to -100, with above -20 considered Overbought, and below -80 considered Oversold (note that its value direction is opposite to RSI/Stochastic).
• Money Flow Index (MFI): Combines price and volume, similar to a volume-weighted RSI. The judgment thresholds are usually 70 (Overbought) and 30 (Oversold).

Key Considerations for Identifying Overbought and Oversold Signals

1. Threshold is not absolute: 70⁄30 or 80⁄20It is a commonly used reference, but not a hard and fast rule. In a strong one-sided trend (such as a bull market or bear market), prices may remain in the Overbought or Oversold zones for an extended period. Indicators may continuously provide “false” signals. At this time, the risk of contrarian operations is very high.

2. Trends are friends: The most crucial point in judging overbought and oversold signals is to combine them with market trends.

   • In a strong uptrend, overbought signals may only indicate a temporary consolidation or slight pullback, rather than a trend reversal. Shorting should be approached with extreme caution.
   • In a strong downtrend, oversold signals may only indicate a brief rebound or a pause, rather than a trend reversal. Bottom fishing requires extreme caution.
   • In a volatile market (consolidation market), the reference value of overbought and oversold signals is usually higher, and prices tend to fluctuate back and forth within a range.
3. Finding Confirmation Signals: Signals from a single indicator may contain noise or be misleading. Using multiple indicators in combination (such as RSI Overbought + price touching the upper Bollinger Band + appearance of bearish candlestick patterns) can significantly improve the reliability of judgments. Divergence is one of the strongest confirmation signals.
4. Time Period: The significance of overbought and oversold signals varies across different time periods (such as daily, 4-hour, and 1-hour charts). Short-term signals occur more frequently but may be false, while long-term signals are more reliable but lag behind. You need to choose based on your trading style.
5. Volume Coordination: When an overbought/oversold signal appears, observe the changes in trading volume. For example, if the overbought area is accompanied by a significant volume stagnation, or the oversold area follows a large panic sell-off with reduced volume, it may enhance the validity of the signal.

Summary: Flexible Application, Avoid Pitfalls

Determining overbought and oversold signals is a fundamental skill in technical analysis, with the core being understanding the principles and application scenarios of tools such as RSI, stochastic indicators, and Bollinger Bands. Remember70⁄30General thresholds should be used, but never mechanically applied. The most important principle is to combine with market trends: follow the trend and use overbought and oversold signals to find opportunities for pullback entries or rebound exits; trading against the trend (especially in strong trends based on overbought and oversold signals) is often dangerous.

Successful traders do not act rashly based solely on an Overbought or Oversold signal. They view these signals as warning lights, combining trend analysis, price patterns, trading volume, and other technical indicators for a comprehensive assessment, and formulate trading plans within a strict risk management framework. Through continuous practice and learning, you will be able to grasp the market pulse more accurately, using Overbought and Oversold signals to enhance the quality of trading decisions.