How to determine overbought and oversold signals?

In the trading markets of stocks, foreign exchange, cryptocurrencies, etc., accurately capturing potential turning points in prices is crucial. Overbought and oversold signals are the core tools used by technical analysts to predict the short-term overheating or overcooling state of the market. They are like the “thermometer” of the market, helping traders identify potential reversal or adjustment opportunities. So, how to judge overbought and oversold signals? The answer lies in the proficient use of a series of classic technical indicators.

##Core Judgment Tools: Analysis of Common Technical Indicators

Relative Strength Index (RSI)

Principle: RSI measures the relative ratio of the price increase to the price decrease over a period of time, with a value range between 0 and 100.

• Criteria for judgment:
  • Overbought signal: It is generally believed that when the RSI value is above 70, the market may be in an overbought state, indicating that the upward momentum may be overextended, posing a risk of pullback or reversal. In very strong trends, the threshold may sometimes be raised to 80.
  • Oversold Signal: It is generally believed that when the RSI value is below 30, the market may be in an oversold state, indicating that the downward momentum may have been excessively released, presenting an opportunity for a rebound or reversal. In very weak trends, the threshold can sometimes be adjusted down to 20.
• Key point: The duration of RSI in the overbought/oversold regions and the divergence phenomenon (price making new highs/lows while RSI does not make new highs/lows) can provide stronger signals.

Stochastic Oscillator

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

• Criteria:
  • Overbought signal: When the %K line or %D line is above 80, the market is considered 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 considered a buy signal) and divergence phenomena are equally important.

Bollinger Bands

Principle: The Bollinger Bands consist of a middle band (usually a 20-day moving average) and two outer bands. The upper and lower bands are based on the standard deviation of the price, representing the dynamic range of price volatility.

• Criteria:
  • Overbought Signal (Potential): When the price touches or breaks through the upper band, it indicates that the price is at a relatively high level and may be in a short-term overbought state.
  • 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 points: Touching the upper and lower bands of the Bollinger Bands is not a direct buy or sell signal; it often needs to be combined with other indicators (such as whether the RSI is simultaneously overbought/oversold) or to observe whether the price is stable outside the bands to determine strength. The Bollinger Bands are more effective in trending markets.

Other auxiliary indicators:

• Commodity Channel Index (CCI): It is generally believed that a CCI above +100 indicates overbought, while a CCI below -100 indicates 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 threshold for judgment is usually also 70 (overbought) and 30 (oversold).

Key Considerations for Identifying Overbought and Oversold Signals

1. Threshold is not absolute: 70/30 or 80/20 are commonly used reference values, but they are not set in stone. In a strong unilateral trend (such as a major bull or bear market), prices may remain in overbought or oversold areas for a long time. Indicators may continue to issue “false” signals. At this time, the risk of counter-trend operations is extremely high.
2. Trends are friends: The most critical point in determining overbought and oversold signals is that they must be combined with market trends.

• In a strong upward trend, overbought signals may only indicate a brief consolidation or slight pullback, rather than a trend reversal. Short selling should be approached with extreme caution.
• In a strong downward trend, oversold signals may only indicate a brief rebound or 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. Look for confirmation signals: A signal 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 a bearish candlestick pattern) can significantly improve the reliability of the judgment. 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 are more frequent but may be false, while long-term signals are more reliable but lag behind. You should choose according to your trading style.
5. Volume Coordination: When overbought/oversold signals appear, observe changes in trading volume. For example, a large volume stagnation in the overbought area or a decrease in volume after panic selling following a large volume in the oversold area may enhance the validity of the signals.

##Summary: Use Flexibly to Avoid Pitfalls Judging overbought and oversold signals is a fundamental skill in technical analysis, with the core focusing on understanding the principles and application scenarios of tools like RSI, stochastic indicators, and Bollinger Bands. Remember universal thresholds like 70/30, but never apply them mechanically. The most important principle is to combine with market trends: trade with the trend, using overbought and oversold signals to find opportunities for pullback entry or rebound exit; 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 a single 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 more accurately grasp the pulse of the market, using overbought and oversold signals to enhance the quality of trading decisions.

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