Overbought and Oversold

Overbought and oversold describe a market that has moved too far, too fast, in one direction. A stock is called overbought after a sharp rise that leaves it stretched above its recent range, and oversold after a sharp fall. The terms are usually defined by a momentum oscillator crossing a fixed level, such as RSI above 70 or below 30. They can also describe the whole market, using breadth: how many stocks are rising or falling, or are above their moving averages.

How it is measured

Each oscillator has its own conventional zones:

For the market as a whole, the classic book version of this indicator was a 10-period exponential average of advancing minus declining issues: strongly positive readings meant the market was overbought, strongly negative ones oversold. The McClellan Oscillator and the percentage of stocks above a moving average do the same job today.

How to read it

• A condition, not a signal. An oversold reading says the selling has been intense; it does not say the selling is over. The more useful signal is the exit from the zone, such as RSI crossing back above 30, which shows momentum turning.
• Trend changes the meaning. In a strong uptrend, stocks become overbought and stay there while they keep rising, and an oversold reading is often a buying opportunity. In a downtrend the reverse is true: oversold readings persist and overbought readings tend to mark the end of bounces.
• Agreement between tools. When two different oscillators, or a stock’s oscillator and the market’s breadth, are both at extremes, the reading is more meaningful than one indicator alone.
• Extremes and divergence. A very deep oversold reading at the start of a sell-off often comes back at a later low, but less deep. That bullish divergence is a stronger sign of a bottom than the first extreme.
• Washouts. Unusually extreme readings can signal a change in character rather than a turning point. A market that becomes heavily overbought at the start of a new rally is showing strength, not exhaustion.

Settings and common mistakes

• Selling because it is overbought. Many of the best-performing stocks spend much of their advance in overbought territory. Check the trend first, for example whether price is above its 200-day average.
• Buying a falling stock because it is oversold. Without a turn in momentum or price, an oversold stock can keep falling. Wait for the oscillator to leave the zone or for a reversal bar.
• One level for every stock. Volatile stocks hit extreme readings far more often than quiet ones. Compare a stock with its own history, or adjust the levels (for example 80/20 for RSI in strong trends).
• The period sets the frequency. Short periods reach the zones often and suit short-term trading; longer periods reach them rarely, so their readings carry more weight.

Live chart: SPY (S&P 500 ETF), daily, with RSI(14) and Williams %R(14), two common overbought and oversold gauges. The chart updates every trading day.

Screen for it on MarketInOut

Stocks in a long-term uptrend where two oscillators agree the stock is oversold:

exch(nyse,nasdaq) and type(stock) and price > 1 and advol(21) > 1
and price > sma(200) and rsi(14) < 35 and wpr(14) < -80

The same idea with a market filter: oversold stocks in an uptrend, but only when fewer than 20% of S&P 500 stocks are above their 20-day average. Most days it returns nothing; it fills up during broad sell-offs.

exch(nyse,nasdaq) and type(stock) and price > 1 and advol(21) > 1
and (a20ma < 20)@sp500 and price > sma(200) and rsi(14) < 40

Related: RSI, Stochastic oscillator, McClellan Oscillator.