Sell when overbought and buy when oversold? This is something to pay close attention to, identifying false signals!

What is overbought and oversold?

"There are no bad stocks, only bad prices." This statement is familiar to many in technical analysis.

In fact, when stock prices are overvalued, the market will anticipate a correction, leading to a possible price decline. Conversely, when stock prices are undervalued, the market will anticipate a rebound, leading to a potential price increase.

Technical analysis rarely considers the fundamentals of stocks, does not have the concept of valuation, and instead focuses on market supply and demand. Therefore, when determining whether the market supply and demand relationship is imbalanced, the evaluation criteria are based on "overbought and oversold".

Learning Benefits: Master more technical analysis trading skills, unlock access to join.Futubull official communication group , with professional tutors and mooers sharing online, click here to join now>>

The so-called overbought and oversold refer to the situation where the price of a stock rises or falls significantly within a period, exceeding the market's equilibrium state. Overbought refers to excessive buying, while oversold refers to excessive selling.

Many people tend to fall into the misconception that when the market shows an overbought signal, they should decisively sell; when an oversold signal appears, they should decisively buy. This strategy is effective in general, but reality is not always so.

How to determine Overbought and Oversold conditions?

There are many technical analysis indicators that can be used to determine Overbought and Oversold conditions, among which the Relative Strength Index (RSI) is one of the most commonly used Overbought and Oversold indicators.

The RSI indicator is a classic momentum oscillation indicator that can reflect the strength of price movements, oscillating between 0 and 100.

Generally, when RSI > 70, the market is in an Overbought condition. If RSI subsequently falls below 70, it is a potential Sell opportunity. Similarly, when RSI < 30, the market is in an Oversold condition. If RSI rebounds above 30, it is a potential Buy opportunity.

The above method of determination is relatively simple and effective in ranging markets. However, in trending markets, especially when the market trend is very strong, the situation may be different. RSI indicator may continue to hover in the Overbought and Oversold zones, releasing incorrect trading signals.

In addition to RSI and other technical analysis indicators, many traders also often use support and resistance levels to determine Overbought and Oversold conditions, and then predict the timing of market retracement or reversal.

Simply put, when the stock price approaches important support levels, it can be considered Oversold; when the stock price approaches important resistance levels, it can be considered Overbought.

3. Case Study

As shown in Figure 1, a certain stock is in an overbought state, with the 14-day RSI indicator crossing the 70 overbought boundary. Furthermore, the upward trend of the stock price is very strong, with retracements being brief and minor.

In this situation, investors should not blindly assume that when the RSI indicator falls below 70, it is the time to bet on a price decline. Because in a super-strong trend, there is a high risk of contrarian trading.

A relatively conservative and reasonable approach is to follow the trend. Simply put, it is "buying on pullbacks in an uptrend" or "selling on rebounds in a downtrend".

Figure 2 is an example of 'buying on pullbacks in an uptrend'. In the case where the uptrend line remains intact, if the RSI indicator falls near the 30 oversold boundary, it may be a potential buying opportunity.

In this example, both the trendlines and RSI indicator play their respective roles: the former helps investors confirm the trading direction, while the latter provides the entry timing.

Figure 3 is a case study using support levels to assist in confirming oversold conditions and predicting price reversals.

On one hand, when the 14-day RSI indicator falls below the 30 oversold boundary, it means the market is in an oversold state. On the other hand, the stock price has reached a horizontal support line, the presence of this support level can increase the possibility of a price rebound.

In conclusion, when the market is overbought or oversold, it does not necessarily mean that the market will soon undergo an adjustment or reversal. Overbought and oversold conditions only indicate that the current market trend is very strong, and investors should not blindly engage in contrarian operations. In some cases, overbought and oversold conditions can also be part of trend trading.

This content discusses technical analysis. Other methods, including fundamental analysis, may provide different perspectives. The examples provided are for illustrative purposes only and do not reflect expected results.

All investments involve risks, including potential losses of principal, and there is no guarantee that any investment strategy will be successful.