Overbought and oversold

"Overbought" and "oversold" describe readings at the extremes of a momentum oscillator. On the RSI, the conventional thresholds are 70 for overbought and 30 for oversold. On the stochastic oscillator they are usually 80 and 20.

The terms sound like judgements about value, but they only describe recent price behaviour. An RSI of 75 means that, over the look-back period, up moves have been much larger than down moves. It says nothing about whether the price is "too high" in any economic sense.

Example

Illustrative figures: USD/JPY rises steadily for two weeks on widening interest rate differentials, and the 14-day RSI reaches 78. A trader who sells simply because the indicator is "overbought" may find the RSI stays above 70 for weeks while the pair keeps rising. Meanwhile, in a sideways range on EUR/GBP, an RSI dipping to 28 near the bottom of the range might coincide with a bounce, because ranges reverse more often than trends do.

Common misconception

The most frequent mistake is treating overbought as an automatic sell signal and oversold as an automatic buy. In a strong trend, oscillators can stay at extremes for long periods, and fading the move can mean a series of losses against the dominant direction. Many traders instead:

• use the levels mainly in ranging markets, alongside support and resistance;
• treat a strong trend's oscillator readings as confirmation of momentum rather than exhaustion;
• watch for divergence, where price makes a new high but the oscillator does not.

Our guide to RSI and MACD explains the maths and common misuses.