What are Overbought & Oversold?
Overbought is a term in technical analysis that describes a situation in which the stock price of a company has risen so much where an oscillator has reached its upper bound. There are different technical indicators that you can use to check if a stock is overbought. Stochastic and RSI are two of the most popular one. When the stochastic rise above the 80 level or RSI cross over the 70 level, that’s when we considered a stock is overbought.
Oversold is just the opposite of Overbought. It describes a situation in which the stock price of a company has falling so much where an oscillator has reached its lower bound. When stochastic drop below the 20 level or RSI cross down the 30 mark, that’s when we consider a stock is oversold.
How to use overbought and Oversold Indicator?
There are different ways that traders use to trade using overbought and oversold indicator.
1. Some traders sell immediately when an oscillator across the overbought area, and buy immediately when an oscillator fall to the oversold area.
2. Some traders do not sell when an oscillator across the overbought area. They will hold their stock until the oscillator starts to fall below the overbought area. Those traders do not buy a stock when an oscillator fall to the oversold area, they buy when the stock price recovers a bit and the oscillator across above the oversold area again.
I personally use method 2. The reason is that some stocks will keep going higher when an oscillator is in the overbought area. If I sell it when an oscillator reach the overbought area, I lose out a lot of profit. There are stocks that would keep falling even when the oscillator is already in the oversold area. It is much safer to buy when the stock recovers a bit and shows signal of going up again or when the oscillator is crossing above the oversold area.
For example, if you were to use approach 1, you would sell CDE on 2/14 or 2/15 base on the stochastic indicator, and would missed out a lot profits on this stock.
