I just noticed that the concepts of Oversold and Overbought still remain one of the ideas that confuse many traders, even though they are basic tools but highly effective.

Simply put, Oversold and Overbought are technical analysis tools that help us determine whether the price is being sold or bought excessively, based on historical price and trading volume data.

When we talk about the Oversold condition, it refers to a situation where an asset has been sold too much, causing the price to fall below its normal level. During this time, selling pressure tends to weaken, and buying interest begins to increase, leading to a potential rebound in price. Conversely, Overbought occurs when the price has been bought excessively, making it too expensive. The likelihood is that buying pressure will weaken and selling will take over.

To measure Oversold and Overbought, we need to use popular indicators such as RSI and Stochastic Oscillator.

RSI indicates the ratio of upward movement to downward movement in price. It ranges from 0 to 100. When RSI is above 70, it means the price is in Overbought territory. When below 30, it indicates Oversold.

The Stochastic Oscillator is similar but shows where the closing price is within the high-low range. When %K is above 80, it’s Overbought; below 20, it’s Oversold.

But here’s the important part – Oversold and Overbought are not immediate buy or sell signals to act on right away. They are merely tools to assist.

There are two main ways to use them: Mean Reversion and Divergence.

Mean Reversion involves when the price fluctuates within a range (sideways). We use Oversold and Overbought to find buy or sell points within that range. For example, when RSI enters an extremely oversold zone, we might look for a buy point and close the position when the price reaches the moving average.

Divergence occurs when the indicator signals a contradiction with the price. For example, the price makes a new low, but RSI does not make a new low. This indicates that the downtrend may be losing momentum and a reversal could be imminent.

What’s important to remember is that Oversold and Overbought should be used in conjunction with other indicators, not relied on solely. These tools help us avoid buying at too high a price or selling at too low a price, but confirming with other tools makes our trading system more accurate.