What does Oversold mean: A beginner's guide to forex trading

In trading and investing, the term oversold means “sold too much” or a condition where an asset has been sold down to a price below its fair value. This is an important concept that helps traders avoid making wrong decisions, such as selling an asset at too low a price or buying at too high a price. In this article, we will explore the deeper meaning of oversold and overbought conditions, as well as how to apply them in real trading.

Oversold and Overbought: Basic Definitions

What does oversold mean? It involves using technical indicators to analyze whether an asset has been sold excessively. When an indicator shows an oversold reading, it signals that selling pressure has weakened and buying interest may be coming in, potentially causing the price to rebound or return to normal levels.

Conversely, overbought refers to a situation where an asset has been bought excessively, pushing the price higher than necessary. At this point, buying momentum may be waning, and selling pressure could increase, causing the price to slow its rise or reverse downward.

These two conditions are not about the intrinsic fair value of an asset but about whether the price has moved too far away from its typical range.

What is an oversold condition?

An oversold condition occurs when an asset has been sold so heavily that its price drops below its appropriate value. Smart traders recognize signs that selling is about to exhaust itself and that buying interest is returning. The result is that the price is likely to stop falling and start to rebound. Tools like Stochastic Oscillator below 20 or RSI below 30 are signals indicating oversold conditions. When you see these signals, it’s better not to sell more just because the price is low; instead, look for buying opportunities.

What is an overbought condition?

In contrast, an overbought condition indicates that an asset has been bought excessively, causing the price to rise beyond its fair level. During this phase, buying momentum is waning, and selling pressure may begin to increase, leading to a slowdown or reversal of the upward move.

Indicators such as Stochastic Oscillator above 80 or RSI above 70 suggest overbought conditions. Experienced traders tend to avoid buying more at this stage because the price is considered too high, and may look for opportunities to short or sell.

Indicators for Overbought and Oversold Conditions

RSI (Relative Strength Index) - Momentum Indicator

RSI is one of the most popular indicators for identifying overbought and oversold states. It compares the magnitude of recent gains to recent losses to measure speed and change of price movements.

Calculation: RSI = 100 - (100 / (1 + RS))

where RS = average gain over N periods / average loss over N periods.

RSI values range from 0 to 100:

• Above 70: Overbought — price may reverse downward
• Below 30: Oversold — price may rebound upward

Note that 70 and 30 are standard thresholds but can be adjusted based on asset behavior.

Stochastic Oscillator - Price Position Indicator

Stochastic Oscillator measures where the current closing price is relative to the high-low range over a set period (commonly 14 days).

Calculations: %K = [(Close - Lowest Low 14 days) / (Highest High 14 days - Lowest Low 14 days)] x 100

%D = 3-day moving average of %K

Values range from 0 to 100:

• Above 80: Overbought
• Below 20: Oversold

This indicator helps traders see where the closing price sits within its recent range, aiding in early detection of trend reversals.

Trading Strategies: Mean Reversion

Mean Reversion assumes that prices which have moved too far from their average will tend to return to that average. This strategy is often used in sideways markets without a clear trend.

Example: RSI-based Mean Reversion

Steps:

1. Identify the primary trend using a 200-day moving average (MA200):

   • Price above MA200: uptrend
   • Price below MA200: downtrend
   • Price oscillating around MA200: sideways

2. Set overbought/oversold zones:

   • Overbought: RSI > 90
   • Oversold: RSI < 10

3. Enter trades when price hits these zones:

   • Buy when oversold
   • Avoid buying when overbought; consider shorting instead

4. Close trades when price reverts toward the 5-day moving average (SMA5)

Case Study: USDJPY on 2-hour candles

In a scenario where USDJPY breaks above MA200 and consolidates:

• Since the trend is upward, oversold signals are less likely, but slight overbought signals may appear.
• Set RSI overbought at 75 and oversold at 35.
• Buy at oversold levels, avoid shorting at overbought.
• Exit when price approaches MA25.

This mean reversion approach works best in sideways markets or when the trend is weak.

Trading Strategy: Divergence

Divergence occurs when the indicator shows a different trend than the price. For example, the price makes higher highs, but RSI makes lower highs, signaling weakening momentum and potential reversal.

Divergence is most reliable when combined with overbought or oversold signals.

Example: RSI Divergence in WTI Crude Oil on 2H candles

• Price forms a double bottom or lower lows.
• RSI shows bullish divergence: price makes lower lows, RSI makes higher lows.
• Enter long when price breaks above MA25.
• Place stop-loss below previous lows.
• Exit when the trend weakens or divergence reverses.

Summary: Using Oversold and Overbought Wisely

Oversold means “sold too much,” and Overbought means “bought too much.” These indicators are tools to avoid selling too cheaply or buying too expensively. Even simple tools like RSI or Stochastic can significantly improve trading decisions.

However, combining these signals with other tools—such as divergence, moving averages, and pattern recognition—can create more accurate trading systems.

Always remember, oversold and overbought are not direct buy or sell signals but helpful clues. Successful traders wait for confirmation from multiple indicators before entering trades. This disciplined approach is what makes oversold and overbought conditions powerful tools in trading.