Overbought and Oversold Stocks in RSI Terms Explained

The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements, typically over a 14-day period. It ranges from 0 to 100 and helps traders identify potential reversal points in the market by determining whether a stock is overbought or oversold.

An overbought condition occurs when the RSI indicator is high, usually above 70, suggesting that the stock might be overvalued and due for a pullback. Conversely, an oversold condition happens when the RSI drops below 30, indicating that the stock may be undervalued and due for a bounce.

Read this article because it explains how to identify overbought and oversold stocks using RSI, helping you make smarter trading decisions.

I’ll answer the following questions:

1. What is the Relative Strength Index (RSI) and why is it important in stock analysis?
2. What do overbought and oversold conditions mean in the context of RSI?
3. How does RSI help in identifying potential market reversals?
4. What are the typical RSI thresholds that signal overbought or oversold conditions?
5. How can traders adjust RSI thresholds based on different market conditions?
6. What are the risks and benefits of trading overbought stocks?
7. Why might oversold stocks present a good buying opportunity?

Let’s get to the content!

Importance of RSI in Stock Analysis

The RSI was developed by J. Welles Wilder in 1978 and has since become a staple in technical analysis. Its popularity among traders stems from its simplicity and effectiveness in gauging momentum and identifying overbought or oversold conditions.

Over the decades, RSI has been widely adopted by traders across a number of markets, from stocks to commodities, due to its ability to provide clear signals in otherwise uncertain market conditions.

Overbought Stocks in RSI Terms

When a stock is overbought, its RSI value has typically crossed above 70. This suggests that the stock has been heavily bought over a short period, and its price might be inflated relative to its recent performance.

The chart below illustrates how RSI works to determine overbought and oversold conditions.

An overbought condition doesn’t guarantee a price drop, but it does indicate that the stock is at a higher risk of correction or consolidation, especially if other indicators confirm the signal.

Historical examples of overbought stocks include:

• Tesla (TSLA) during its rapid ascent in 2020, where RSI levels frequently exceeded 70.
• Apple (AAPL) after significant product launches, often driving the stock into overbought territory.
• Bitcoin (BTC) in late 2017, where extreme buying pushed RSI levels well above 70 before a sharp correction.

Identifying an overbought condition is a great way to manage your risk when you trade. To learn more strategies for managing risk, check out my video below.

Overbought Condition (High RSI) Definition

Get my weekly watchlist, free

Sign up to jump start your trading education!

Send me your weekly watchlist

100% Privacy. I will never spam you!

An overbought condition is defined by an RSI reading above 70. This high RSI measure indicates that buying pressure has pushed the stock’s price to an unsustainable level, increasing the likelihood of a pullback or sideways movement. The typical threshold that signals an overbought condition is:

• RSI above 70: Commonly accepted as the level where a stock is considered overbought.
• RSI above 80: Indicates extreme overbought conditions, often leading to stronger corrective actions.

Implications of Overbought Stocks

Overbought stocks often lead to increased volatility as the market reacts to the inflated prices. This volatility can present both opportunities and risks for traders.

A stock entering overbought territory might continue to rise if the momentum is strong, but it could also experience a sharp decline if traders begin taking profits or if negative news triggers a sell-off.

Common reactions to overbought stocks include:

1. Profit-taking: Investors may sell their positions to lock in gains.
2. Short-selling: Traders might short the stock, betting on a price decline.
3. Market correction: The broader market may adjust, especially if multiple stocks are overbought.

Oversold Stocks in RSI Terms

An oversold stock has an RSI value below 30, indicating that it has been heavily sold and may be undervalued. This condition often precedes a rebound as traders and investors recognize the value and start buying.

Like overbought conditions, the oversold label doesn’t guarantee an immediate price reversal but suggests a potential buying opportunity.

Historical examples of oversold stocks include:

• General Electric (GE) in late 2018, where the stock’s RSI dipped below 30 during a period of significant corporate restructuring.
• Amazon (AMZN) during the 2008 financial crisis, presenting a strong buying opportunity.
• Oil prices during the 2020 COVID-19 crash, where extreme selling pushed RSI levels into oversold territory.

More Breaking News

• Beneficient Stock Surge: Is it Time to Jump on the Bandwagon?
• Is BJ’s Wholesale Club on the Verge of a Major Breakthrough?
• ANF Stock Rise Predicted: Citi’s Positive Outlook and Q3 Earnings Buzz

Oversold Condition (Low RSI) Definition

An oversold condition is defined by an RSI reading below 30. This low RSI value indicates that selling pressure has driven the stock’s price down, possibly beyond its intrinsic value, creating an opportunity for a price rebound.

The typical RSI thresholds signaling an oversold condition are:

• RSI below 30: Generally indicates a stock is oversold and may be due for a bounce.
• RSI below 20: Suggests extreme oversold conditions, increasing the likelihood of a sharp reversal.

Implications of Oversold Stocks

Oversold stocks may signal a potential buying opportunity, as the market might correct an overreaction to negative news or events. However, it’s crucial to analyze the broader market conditions and confirm the signal with other indicators to avoid catching a falling knife.

Common reactions to oversold stocks include:

1. Bottom fishing: Investors buy stocks at perceived bargain prices.
2. Short covering: Short sellers buy back shares to cover their positions, driving prices up.
3. Momentum reversal: The stock may enter an uptrend as buying interest returns.

Analyzing RSI Charts to Identify Overbought and Oversold Conditions

You should use RSI charts to identify overbought and oversold conditions by looking for levels where the RSI crosses above 70 or below 30. Watch for these conditions and confirm them with other indicators or patterns to avoid false signals. Understanding the RSI’s context, such as the overall market trend and specific stock news, is critical for accurate interpretation.

To interpret RSI trends on charts, follow these steps:

1. Set your RSI period: Typically 14 days, though some traders adjust it to 10 or 20 days.
2. Identify RSI crossovers: Look for the RSI crossing above 70 for overbought signals or below 30 for oversold signals.
3. Confirm with other indicators: Use volume, moving averages, or trend lines to validate RSI signals.

Every trader should be able to recognize not only traditional RSI signals but also hidden divergences, which can provide early indications of potential reversals before they become obvious on standard charts. A hidden divergence occurs when the RSI moves in the opposite direction of the price, signaling a continuation of the current trend rather than a reversal.

Learn more about spotting these opportunities in my article about RSI hidden divergence.

Trading Overbought and Oversold Stocks With RSI

Trading based on RSI indicators involves looking for points where the RSI indicates overbought or oversold conditions and making strategic trades accordingly. However, relying solely on RSI can be risky, as it’s just one of many indicators. Combining RSI with other indicators, like moving averages or support and resistance levels, enhances the reliability of your trades.

When using RSI, consider combining it with:

• Moving Averages: To confirm the trend direction.
• Volume Analysis: To gauge the strength behind the RSI signal.
• Support and Resistance Levels: To identify potential entry and exit points.

If you want to leverage the power of RSI along with other technical indicators like those mentioned above, you’ll need a robust trading platform.

When it comes to platforms, StocksToTrade is first on my list. It’s a powerful day and swing trading platform that integrates with most major brokers. I helped to design it, which means it has all the trading indicators, news sources, and stock screening capabilities that traders like me look for in a platform.

Grab your 14-day StocksToTrade trial today — it’s only $7!

Trading Oversold Stocks

Buying stocks in oversold conditions can be lucrative, especially if you catch a rebound early. Look for signs of stabilization in the RSI and confirm with increasing volume or a break above resistance levels.

Key indicators suggesting an oversold stock is a good buy include:

• RSI crossing back above 30: Indicates the start of a recovery.
• Volume increase: Suggests rising interest in the stock.
• Price breaking above a key resistance level: Confirms a potential trend reversal.

Handling Overbought Stocks

When dealing with overbought stocks, you must decide whether to sell, hold, or short. Selling into strength is a common strategy, especially if other indicators suggest a price decline. However, if the stock continues to show strong momentum, holding might be justified.

Key indicators suggesting an overbought stock should be sold or held include:

• RSI crossing below 70: A potential sell signal.
• Divergence between price and RSI: Suggests weakening momentum.
• Volume decreasing: Indicates fading buying interest.

RSI Threshold Adjustments

You should adjust your RSI thresholds based on market conditions in order to optimize your trading strategy. In volatile markets, you might raise the overbought threshold to 80 and lower the oversold threshold to 20 to capture more extreme price movements.

Situations where adjusting the RSI threshold is beneficial include:

• High-volatility markets: Use 80/20 thresholds to avoid premature signals.
• Strong trending markets: Adjust RSI to 60/40 to align with the trend.
• Different asset classes: Fine-tune RSI levels to match the typical behavior of the asset.

One advanced strategy to consider when adjusting RSI thresholds is the RSI setup tailored for specific market conditions. For instance, in markets with prolonged trends, adjusting the RSI to a higher overbought threshold like 80 or a lower oversold threshold like 20 can help filter out noise and focus on stronger signals.

This customization allows traders to stay aligned with the market’s momentum, making their trades more effective and reducing the risk of premature exits. Learn how to implement this strategy in my guide to RSI setups.

Risk Management

Risk management is vital when trading overbought or oversold stocks. Always have a plan for cutting losses if the trade goes against you. Use stop-loss orders, position sizing, and never risk more than a small percentage of your account on a single trade.

Risk management strategies specific to RSI trading include:

• Setting stop-loss orders below support or above resistance: To limit potential losses.
• Using trailing stops: To lock in gains as the trade moves in your favor.
• Avoiding overleveraging: Keep your positions within a safe range to reduce risk.

In addition to the basic RSI setups, traders should master RSI divergence in order to predict trend reversals with greater accuracy. Divergence occurs when the price movement and RSI trend don’t align, often indicating that the current trend is losing momentum.

By incorporating RSI divergence into your strategy, you can improve your timing and reduce the risks associated with false signals. Check out my article about RSI divergence to explore the benefits in detail.

Benefits and Risks of Trading Overbought Stocks

Trading overbought stocks can offer quick profits, but the risks are significant. The potential for a sharp reversal is high, meaning you should stay alert and manage your positions carefully. However, with proper analysis and risk management, the rewards can outweigh the risks.

Real-world examples of successful and unsuccessful trades of overbought stocks include:

• Successful: Shorting Bitcoin (BTC) in late 2017 after RSI reached extreme levels.
• Unsuccessful: Holding Tesla (TSLA) through a correction in 2021 after it became overbought.

Potential for Quick Profits

Trading overbought stocks can lead to quick profits, especially in fast-moving markets. Improve your results by timing your entry and exit precisely, capitalizing on short-term price movements before the trend reverses.

Factors that increase the potential for quick profits in overbought conditions include:

• High trading volume: Indicates strong market interest.
• Positive news catalysts: Can push prices higher temporarily.
• Strong overall market trend: Supports the stock’s momentum.

Riding the Momentum

Riding the momentum of overbought stocks can be profitable, but it requires careful monitoring. The strategy involves holding the stock as long as it continues to rise, then selling at the first sign of weakness.

Examples of momentum trading with overbought stocks include:

• Buying into a strong uptrend: Like Apple (AAPL) during a new product launch.
• Riding a short squeeze: As seen with GameStop (GME) in early 2021.

Reversal Risk

The risk of price reversals in overbought stocks is significant. Even a minor change in market sentiment can lead to a sharp decline, turning potential gains into losses quickly.

Signs that an overbought stock is about to experience a price reversal include:

• Bearish divergence between RSI and price: Suggests weakening momentum.
• High trading volume with no price advance: Indicates exhaustion of buying interest.
• Negative news or earnings reports: Can trigger a sharp sell-off.

Increased Volatility

Overbought conditions can lead to increased market volatility as traders react to the high prices. This volatility can make trading more challenging but also more rewarding for those who can navigate it effectively.

Examples of how volatility affects trading decisions for overbought stocks include:

• Tesla’s (TSLA) swings: After RSI hit overbought levels in 2020.
• Cryptocurrency market fluctuations: Following periods of extreme buying pressure.

Benefits and Risks of Trading Oversold Stocks

Trading oversold stocks offers potential rewards but also significant risks. While the chance of catching a rebound can lead to substantial gains, the possibility of further declines must not be ignored.

Real-world examples of successful and unsuccessful trades of oversold stocks include:

• Successful: Buying Amazon (AMZN) during the 2008 financial crisis.
• Unsuccessful: Catching falling knives with Enron before its collapse.

Buying Opportunity

Oversold stocks often present a good buying opportunity, especially when the market has overreacted to negative news. If the fundamentals remain strong, these stocks can offer significant upside once the selling pressure subsides.

Factors that make an oversold stock a compelling buy include:

• Strong company fundamentals: Indicate the stock is undervalued.
• Reversal in broader market sentiment: Can trigger a recovery.
• Insider buying: Suggests confidence from company executives.

Reversal Potential

The potential for price reversals in oversold stocks is high, especially if the RSI begins to rise. These reversals can lead to rapid gains as the stock recovers from an oversold condition.

Examples of oversold stocks that have successfully reversed include:

• General Electric (GE) after hitting oversold levels in 2018.
• Apple (AAPL) during brief market corrections.

Continued Downtrend

The risk of a continued downtrend in oversold stocks is real. Just because a stock is oversold doesn’t mean it will rebound. It’s crucial to assess the broader market conditions and the specific reasons for the stock’s decline before making a move.

Signs that an oversold stock may continue to decline include:

• Persistent negative news flow: Indicates ongoing issues.
• Weak volume on attempted rebounds: Suggests lack of buying interest.
• Breaking key support levels: Often leads to further declines.

False Signals

False signals in RSI readings for oversold stocks can lead to premature buying decisions. It’s essential to distinguish between genuine buying opportunities and false signals that could lead to further losses.

Tips for distinguishing false signals from genuine buying opportunities include:

• Waiting for confirmation: Such as RSI crossing back above 30.
• Using multiple indicators: To validate RSI signals.
• Monitoring volume trends: To gauge the strength of the move.

How Often Do Overbought and Oversold RSI Conditions Occur in the Market?

Overbought and oversold RSI conditions occur more frequently in volatile markets where price swings are more pronounced. The frequency of these conditions can vary significantly based on market conditions, with certain periods seeing more extreme RSI readings.

Factors that influence the occurrence of these conditions include:

• Market volatility: Higher volatility leads to more frequent RSI extremes.
• Economic news: Can trigger significant price movements.
• Company-specific events: Such as earnings reports or product launches.

Key Takeaways

• RSI is a valuable tool for identifying overbought and oversold conditions.
• Overbought stocks are not always immediate sell signals but do require caution.
• Oversold stocks can present buying opportunities but carry risks of further declines.
• Combining RSI with other indicators improves the reliability of your trades.
• Adjusting RSI thresholds based on market conditions can optimize your strategy.

Trading isn’t rocket science. It’s a skill you build and work on like any other. Trading has changed my life, and I think this way of life should be open to more people…

I’ve built my Trading Challenge to pass on the information I had to learn for myself. It’s the kind of community that I wish I had when I was starting out.

We don’t accept everyone. If you’re up for the challenge — I want to hear from you.

Apply to the Trading Challenge here.

Trading is a battlefield. The more knowledge you have, the better prepared you’ll be.

Are technical indicators part of your trading toolkit? Write “I’ll keep it simple Tim!” in the comments if you picked up on my trading philosophy!

Frequently Asked Questions

Can Stocks Remain Overbought or Oversold for Extended Periods?

Yes, stocks can remain overbought or oversold for extended periods, especially in strong trending markets. This persistence can lead to frustration for traders expecting a quick reversal. It’s important to combine RSI with other indicators and market analysis to gauge the likelihood of a trend continuation or reversal.

Are There Specific Sectors Where Low or High RSI Is More Significant?

Certain sectors, like technology or biotech, often exhibit more extreme RSI readings due to their inherent volatility. In these sectors, a high RSI might indicate a strong trend continuation, while a low RSI could signal an impending rebound.

Is It Possible to Profit from Stocks in Overbought or Oversold RSI Zones?

Yes, it is possible to profit from stocks in overbought or oversold RSI zones, but it requires careful analysis and timing. Understanding the broader market context and using additional indicators to confirm RSI signals are key to successful trading in these zones.

What Role Does RSI Play in Analyzing Price Action?

RSI is a crucial tool for understanding price action, as it reflects the momentum behind price changes by comparing the magnitude of recent gains to recent losses. This formula provides a clear view of the underlying strength or weakness in a stock’s price movements, helping traders anticipate potential reversals at significant highs or lows.

Can RSI Predict Future Price Changes?

RSI doesn’t predict future price changes directly but indicates potential turning points by identifying overbought or oversold conditions. When the RSI reaches extreme values, it signals that the current trend may be losing steam, suggesting that price changes are likely to occur soon. However, RSI should be used with other indicators and market data to confirm the timing and direction of these changes.

How Does RSI Relate to Interest Rates and Securities?

While RSI focuses on the momentum of a security’s price, interest rates can influence these price movements by affecting broader market conditions. For example, rising interest rates might pressure stocks, leading to lower RSI values as selling increases.

Can RSI Be Applied to Non-Stock Securities Like CDs or Bonds?

RSI can be applied to various securities, including CDs and bonds, though its effectiveness may vary depending on the asset’s volatility. For less volatile instruments like CDs, RSI might not provide as clear signals as it does for more volatile securities like stocks.

How Should I Adjust My RSI Strategy Based on Historical Highs and Lows?

When analyzing securities with significant historical highs and lows, adjusting your RSI strategy involves paying close attention to how the RSI levels correlate with these extremes. By examining past data, traders can set more precise RSI thresholds that reflect the unique price action of a security, leading to better insights into future trends.