You may have heard from time to time that an asset is overbought or oversold. What does it mean, and how can one operate with it?
The concepts of overbought and its opposite oversold are quite clear. If an asset is overbought, it means people have bought too much of it, the price is too high, and logic says that it should go down for a while.
There are many ways to measure if an asset is overbought, but here we will talk about two of them. It is not that we think they are the best, but just that they are easy to find in any technical chart service.
Relative Strength Index (RSI)
This index oscillates between zero and one hundred, and most people take 70 as the line that marks the overbought level and 30 as the one that marks the oversold level.
Its basic formula is as follows:
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]
It is tempting to run to a chart, check the RSI, and buy according to its value, but sadly things are not so easily. If they were, you would see more rich people on the streets. We will come back to this later in this article; but before that, let’s see another indicator.
Bollinger Bands
Bollinger Bands are based on moving averages. The system calculates a moving average, and then it adds and deduct a standard deviation value (usually 2.5).
When you do this in a chart, you get three lines, and price is among the top and bottom one a very high percent of the time. Thus, when the price touches or surpasses the top band, it is overbought; and when it surpasses the low band, it is oversold.
As we said with the RSI, things are not as simple as buying when it is oversold.
How to Use These Indicators
The market is not easy; and while buying when oversold and selling when overbought may work for a time, it will not work in the long-term.
When investing in markets, trends are more important than concepts like overbought and oversold. You have more chances if you buy when a price is oversold, but the trend is bullish. This means that chances are you are looking at a rebound, and sooner or later the price will come back to the trend. With that said, remember to use stop loss just in case.
They are also useful to spot divergences. For example, it is usually a bad sign that a top in the price is not linked to a top in the indicators. If the price has gone higher than the previous top, look for the same in the indicator; and if you do not find it, you should be suspicious. If the indicator confirms the top, then you can expect that the price will continue in the same direction (maybe after a small correction).
It is also important to check the previous behaviour of the asset. The fact that people look at 30 and 70 levels in RSI or 2.5 deviation in Bollinger Bands does not mean that these levels will work for the asset you are looking at. For example, NASDAQ assets are usually very volatile, and you may want to use more extreme levels, like for example 20 and 80 in the RSI.
Keep in mind that when the trend is strong, it is normal for an asset to keep the price on overbought or oversold levels for a while. These indicators may help you make decisions, but they should not be the only reason to make them.