Overbought and oversold
What do traders mean when they call a market overbought or oversold, and what do those labels not tell you?
In plain words
Overbought and oversold are labels for moves that have already stretched far in one direction, often judged by how unusual the return is versus a market's own history. They describe how extended a price looks, not when the move will turn.
Why it matters
A stretch label can prompt a trader to size down or expect a reversal, but the label carries no date for when the stretch ends. Markets can stay extended for weeks, so treating 'overbought' as a signal to sell has repeatedly cost money as the trend continued.
In a real week: ETH, week of 26 July 2021
In the week of 26 July 2021, ETH rose 16.71%, a return in the 91st percentile of its 180 weeks of history, and closed at 2555.69, in the upper third of the week's range. Yet ETH was still 41.02% below its 52-week high, and volume was 0.66 of its prior 12-week average. A stretched reading without a matching volume surge said little about when the run would end.
A common mistake
Reading 'overbought' as a sell signal with an implied timer. The label describes how far price has already travelled, not how much further it can travel or when it will reverse.