Using The Moving Average To Determine Overbought Oversold Levels

The moving average can be use as an extra confirmation of overbought oversold levels. It gives the trader a realistic view on how far the stock can move before it snaps back.

For the purpose of determining overbought oversold levels in the daily chart, we will use the 200 day moving average.

The best way to illustrate how it works is for you to imagine the 200 MA as a dog leash and the stock as the dog. Whenever the dog gets too far away from the leash, the leash will yank the dog back. Likewise the 200 MA has a way to bring a stock back to meet it.

Take a look at the charts of a few stock and you will notice that sooner or later, the stock will meet its 200 MA again.

In the chart above, you can see how AAPL got too far from its 200 MA in February and May. It eventually moved back up and meet the 200 MA. In October, AAPL rose and moved far away from its 200 MA. It eventually fell back to meet its 200 MA.

In the chart above, you can see how the SPX fell from January to February. It moved far away from the 200 MA but eventually it snap back up to meet its 200 MA.

Please note that it does not mean a stock will revert back to its 200 MA every time it moves too far away from the 200 MA. What it means is we should be careful when it does so. It helps us to be realistic on the stock's move.