Overbought indicators: what they actually measure
intermediate
Automated material · TradeAlmanac editorial deskPrepared by a language model from our stored data and checked by an editor.
Oscillators such as the relative strength index measure how fast and how far a price travelled over recent periods.
What a high reading means
That the rise was fast. Not that the security is expensive, and not that it will reverse.
A strong security in a sustained trend shows high readings for a long time — and keeps rising throughout.
Where oscillators are more useful
In a range, when the price oscillates within bounds. There, reversion to the mean genuinely happens more often.
The irony is that whether a trend or a range is in progress can only be determined in hindsight.
Divergence
A disagreement between the direction of price and the direction of the indicator is treated as a precursor of a reversal. Sometimes a reversal follows; sometimes the divergence persists and resolves with the trend continuing.
How to treat them
As a description of the speed of a move. That is useful: knowing a security rose quickly changes the assessment of the risk of entering right now.
As a signal — with caution proportionate to the fact that the decision to own a business is not made on the speed of its quote.
Related: Moving averages: smoothing rather than a signal and The limits of technical analysis.
Prepared by a language model from our stored data and checked by an editor.
How we use language modelsSimilar articles
- The limits of technical analysisIt describes price behaviour and disciplines action. It cannot predict the future, and an honest discussion of it starts there.
- Trading volume: the only dimension besides priceHow many securities changed hands. It shows the degree of participation, not the direction.
- Moving averages: smoothing rather than a signalThe average price over a period. It shows the direction of a move that already happened and lags it by construction.
- Support and resistance: why they sometimes workPrices where movement stalled before. The mechanism is participants' memory rather than a property of the market.