How Can We Find Out If A Stock is Overbought or Oversold?
Disclaimer: This is not financial advice, merely a dude attempting to simplify the knots of numbers, bar charts and lines. When it comes to investment, we’ve all probably heard, at least peripherally, of the terms: Fundamental Analysis (FA) and Technical Analysis (TA). Before I start to bore you (or myself really), let me begin by saying sophistication in the market does not necessarily yield results. At the end of the day, investment is about buying something at a lower price and selling it for a higher price. After all the analysis has been done, ultimately it boils down to actions. If we’re not making an informed decision to buy/sell/do nothing, chances are we’re unsure of the circumstances. This is why FA and TA is important. FA is the common approach to establish the intrinsic value of an asset or business, whereas TA is the practice of examining previous market events to predict future trends.
In short, FA tells us what to buy and TA tells us when to buy it.
In this article, I’ll be focusing on TA, specifically the indicator — Relative Strength Index (RSI). It is a tool that we can use to measure the magnitude of price movement as well as the speed (velocity) of these movements. By default, the RSI measures the changes in an stock’s price over 14 periods (14 days on daily charts, 14 hours on hourly charts, and so on). If you’re into formulas, it divides the average gain the price has had over that time by the average loss it has sustained and then plots data on a scale from 0 to 100. Surprise surprise (!?), you don’t need to do this manually. Just go to any price chart comparison sites such as TradingView, key in the stock that you’re keen in, look for “Indicators” on the top, type in RSI and click it.
It’ll take you less than a minute to spot overbought or oversold market conditions.
When momentum increases and the price is rising, it indicates that the stock is being actively bought in the market. If momentum increases to the downside, it is a sign that the selling pressure is increasing. RSI evaluates the asset price on a scale of 0 to 100, considering the 14 periods. Note: you can tweak to whichever period you want with the general idea that lower period means shorter timeframe and longer periods indicate longer timeframe. in that sense, a 7-day RSI is more sensitive to price movements than one which considers 21 days. To find out whether an asset is overbought or oversold, we take a look at the RSI score. An RSI score of 30 or less suggests that the asset is probably close to its bottom (oversold), a measurement above 70 indicates that the asset price is probably near its high (overbought) for that period. If you’re looking into short-term trading setups with less likelihood of false signals, you probably will adjust the RSI indicator to consider higher ranges such as 20 and 80 being the oversold and overbought levels.
Essentially, we’re all eyeing for oversold opportunities when the RSI is hovering between 22 to 35.
This isn’t a magic formula that will instantly make you rich. It isn’t the case that if you happen to buy something that the RSI indicates to be severely oversold, the price action will shoot up to the moon. It is crucial to keep in mind that there is no technical indicator that is 100% efficient, especially if it is used alone. We ought to consider using the RSI indicator along with other indicators to further motivate our conviction as to whether it is the right time to buy an asset. That being said, by now it should be obvious that you shouldn’t buy something when it is overbought. Let’s take a slightly deeper dive.
We can also use RSI to predict trend reversals by spotting bullish and bearish divergences.
A bullish divergence is a scenario when the price and the RSI scores move in opposite directions. RSI score rises which creates higher lows, while the price falls, creating lower lows. This is known as a bullish divergence as the buying force is getting stronger despite the price is on an downwards trend. On the flipside, a bearish divergence is the scenario whereby despite a rise in price, the market is losing momentum. The RSI score drops which creates lower highs and the asset price increases which creates higher highs. It is imperative to note that when it comes to RSI divergences, it is better suited for less volatile markets (hint: stay away from RSI divergences if you’re toying with anything further than the top 30 market caps for crypto or penny stocks.)
There we have it, an easy indicator for the lazy investor.
I should probably end this off with something less taxing on the mind. The thing about personal finance and investment is that there are a ton of diluted content out there. Most are surface-level crap that banks on the sexiest ways to earn 10–1000x in the shortest time possible and ironically still trying to earn more by retaining media attention on their platform. Personal finance is supposed to be personal. We all have varying degrees of optimism for the future and we’re in different life stages managing different kinds of risk and priorities. Everyone’s situation is different.
I genuinely believe some of us are more suited for adopting the simple strategy of parking money into S&P 500 for decades (or 8.6% interest on Blockfi).
You wouldn’t have the craziest of gains, but you probably can ease your way into a joke by saying you beat XXX% of portfolio managers who do not consistently beat the market. Someday, we’ll have our own rich story to share and I wouldn’t be surprised if our richness doesn’t come in the form of how many bitcoins we own, but in the form of human relationships. You can put a number as to whether a stock is overbought or oversold, and there will be market regimes along with circular trends. But you can’t put a number to a relationship you cherish, to a relationship you’re complacent with and when it is gone; it is gone.
