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The stock market doesn't move in a straight line, rather it zigzags higher (or lower) in response to alternate waves of buying and selling pressure. When we speak of the market as being "overbought" we mean that buying pressure has persisted long enough that it is likely to be exhausted. The reverse is true when the market is oversold.
A good way to determine the market's condition (overbought/oversold) across a range of time frames is to analyze the percentage of stocks above their 20-, 50-, and 200-day moving averages. When a stock is above a moving average it is considered bullish, and the stock can be considered to be in a rising trend for that time frame. The percentage of stocks above their 20-, 50-, and 200-day moving averages is a set of similar indicators that give us a measure of market conditions in the short-, medium-, and long-term respectively. The chart shows this set of indicators for the stocks in the S&P 500 Index, but we track these statistics for several major market and sector indexes.
All three indicators have the same range, and you will notice that the shorter-term 20-EMA index moves from one extreme to the other with greater frequency than the medium-term 50-EMA or long-term 200-EMA indexes. When all three indicators are aligned at the same extreme level within the range, it normally signals that an important top or bottom is near.
During a bull market, overbought conditions are not grounds for going short, but they will generally result in corrections or consolidations, so it is a good time to take a closer look at stop loss points.