What Are the Oversold and Overbought Conditions
To understand how to use the RSI indicator in swing trading, first define oversold and overbought conditions.
The rule of supply and demand applies in all markets. Assets, particularly financial assets, follow the supply-and-demand formula. If the supply exceeds the demand, the asset’s value will most certainly decrease. If demand exceeds supply, the asset’s value will most likely rise.
In financial markets, such as equity indexes, the value of a financial instrument can grow too much, and typically too soon. During certain circumstances, the price is commonly referred to as overbought.
On the other hand, there are times when the value of a financial instrument declines too dramatically, and often too soon. Investors and traders refer to such scenarios as oversold.
The graphic below shows a chart with RSI added to it, with oversold and overbought levels noted with arrows.
In these circumstances, markets frequently react with a trend reversal to reset prices. In an overbought condition, market prices will reverse downwards, whereas in an oversold condition, market prices will reverse upwards. Mean reversion trading takes use of this market propensity.
