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The Visual Investor: How to Spot Market Trends, Second Edition by JOHN J. MURPHY

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CHAPTER 5
Is It Overbought or Oversold?

MEASURING OVERBOUGHT AND OVERSOLD CONDITIONS

There are several ways to determine when a market is overbought or oversold. The most effective way is to use an indicator called an oscillator. Oscillators tell us when a market has reached an extreme in either direction, which makes it vulnerable to a countertrend correction. When a stock has gone up too far, analysts will often say that the stock is overbought. That simply means that the stock may have to pause for a while to digest those gains, or possibly have to correct downward before resuming its uptrend. At a stock’s most extreme highpoint, some traders will take profits and temporarily halt the advance. Other buyers will reemerge during the ensuing price setback, and the stock will eventually be pushed higher. An oversold condition is just the opposite, and implies that a stock has fallen too far and is probably due for a short term bounce. It’s generally better to buy a market when it’s oversold and sell when it’s overbought (see Figure 5.1).

DIVERGENCES

There’s a second element in oscillator analysis that is extremely valuable. Not only do oscillators help us determine when a market is overbought or oversold, but they also warn us in advance when a divergence is building up in a stock. Divergences usually warn of an impending trend reversal. We’ve encountered the idea of divergence in our discussion of on-balance volume in Chapter 3. In other words, we study two lines that usually ...

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