How To Determine Overbought and Oversold Conditions and Trade Profitably

How to trade overbought and oversold zones

First things first – equities are an asset class and any quality stock will appreciate over a period of time.

When stocks like Jubilant Foods, HUL, Reliance, etc., started their move upwards, there was no stopping them irrespective of the fact these stocks appeared overbought at many points.

The reverse is true for stocks like PC Jewellers, Gitanjali Gems, Manpasand, etc.

Therefore, equities are in a state of flux, and your job as a trader is to predict entry and exits as the market marches on without bothering about overbought or oversold levels.

You know why?

This example will clear it for you:

Reliance was overbought 950, 1100, and 1200 and it is yet still going strong.

Likewise, IGL was oversold at 279 (Stochastic below 20) and yet went on to test 240 levels.

When consider a stock as “overbought” or “oversold,” it is possible that you will develop an aversion towards trading in it when the price goes against your mental makeup.

Traders think with their eyes, and therefore they must not judge stocks. They should trade with the trend and bring the profits home.

Secondly, do not blindly short when a stock enters an oversold zone in any technical indicator, and vice versa. Apply this technique for meaningful and profitable trades.

Trading Tools Required:

INDICATORS

50 EMA

STOCHASTIC (14, 1, 3)

ASSUMPTIONS

1. When price is BELOW 50-Period EMA, the trend is BEARISH –  sell and buy

1. When price is ABOVE 50-Period EMA, the trend is BULLISH –  buy and sell

CANDLE PERIOD

Daily Candles.

1. MARKING STOCHASTIC OVERSOLD TRADING ZONES AND SHORTING

(Yeah, shorting – you read that right)

A. Marking Oversold Levels

Here is the daily chart of Indraprastha Gas (IGL).

how to trade oversold stochastic

Remember that in this example we are interested in SHORTING because the CMP is BELOW the 50 Period EMA.

Here is how you should mark the oversold zones and levels:

1. When Stochastic dips below 20, mark the price by drawing a horizontal line.

2. Wen the CMP was below the 50 EMA, I discovered 5 instances wherein Stochastic had dipped below 20. These are marked A to E.

3. The price points at the time when the Stochastic dipped below 20 have been marked A to E.

B. Trading Strategy

1. Remember that we want to short and cover because the CMP is below the 50 EMA.

2. We should short when the price BREAKS BELOW a marked level. For example, short when price falls below A or B or C or D or E UNTIL the price crosses the 50 EMA. (Note that the price hasn’t crossed below point E, so that becomes a good short term support).

3. In this strategy you will not buy until price crosses 50 EMA. But that is another story altogether.

2. MARKING STOCHASTIC OVERBOUGHT TRADING ZONES AND BUYING

(Yeah, BUYING – you read that right)

A. Marking Overbought Levels

Here is the daily chart of Reliance Industries.

How to trade overbought levels

Remember that in this example we are interested in BUYING because the CMP is ABOVE the 50 Period EMA.

Here is how you should mark the oversold zones and levels:

1. When Stochastic crosses above 80, mark the price by drawing a horizontal line.

2. Wen the CMP was above the 50 EMA, I discovered 3 instances wherein Stochastic had crossed above 80.

3. The price points at the time when the Stochastic crossed above 80 have been marked A to C.

B. Trading Strategy

1. Remember that we want to buy first and sell at a profit because the CMP is above the 50 EMA.

2. We should buy when the price CROSSES ABOVE a marked level. For example, buy when price crosses A or B or C UNTIL the price falls below the 50 EMA.

3. In this strategy you will not short until price crosses below the 50 EMA. But that is another story.

3. HOW TO DISCOVER STOCKS JUST RIGHT FOR THIS STRATEGY

Set up the following screener to discover opportunities, and then apply the techniques above on the chart:

BULLISH: CMP Greater Than EMA 50

BEARISH: CMP Lesser Than EMA 50

Well, that’s it. Go ahead and apply this strategy and drop in a line if it worked out well.

I’m sure it will.

12 Comments on "How To Determine Overbought and Oversold Conditions and Trade Profitably"

  1. Request study result with RSI and MA, P-V breakout and MA

  2. sir, stop loss for this strategy ?

  3. Significant improvements in the content of this site over the last one year. I again chanced upon your site again by starting following you on twitter. Find the difficult topics explained in very simple language. Quite useful, has changed my outlook on selling and buying time

  4. Well explained. Super, helpful for beginners.

  5. Raajeev Kumar | August 28, 2018 at 2:40 pm | Reply

    Mr. Tinani, but where and when to exit

    Thanks,

    Raajeev Kumar

  6. Interesting technique. Really I will start using right away. Thanks and looking forward to your further useful yet lucid articles

  7. thanks good observatoin.
    I m trading breakouts with system stoplosss but never used any indicator.
    Any other indicator can be useful for identification of overbought or oversold level?
    As per your opinion which incdicator is widely used for OVER b/s zones.
    Again thanks and keep sharing your valuable guidence.

  8. Hi Sir,
    If I choose IGL, CMP is (Today’s close 288) and 50 Day EMA is 281.79 which confirms us bullishness in stock. However, Stochastic is around 30 & 38.
    And same with bharat forge. EMA 50 has crossed CMP. However, stochastic is aroun 77, 82
    Should we still remain bullish on IGL?

    • Okay, you mean Indraprashta Gas.. I took it to mean India Glycol.. Here are the answers:

      1. In this technique, for bullish stocks, you have to mark entry levels when stochastic crosses 80.

      2. Please read the article again. Nowhere is it said that you have to buy or sell a stock when Stochastic hits a particular level.

  9. Very well explained sir.

    But previously people say buy when stock is above 50 day ema n stoch or rsi just above resistance levels+ above 65.

    Plz explain significance of 89 ema if any ?

    • There are many Stochastic strategies. This one helps you trade in overbought and oversold stocks.

      89 is a Fibonacci number. Many followers of Fibonacci’s theories use it. No special significance.

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