What is an Oversold Bounce
An oversold bounce is a rally in prices that occurs due to the selloff preceding it being perceived as too severe.
BREAKING DOWN Oversold Bounce
Before an oversold bounve, due to behavioral tendencies such as herding behavior, aversion to loss, and the temptation to panic, prices can decline more than they should based on technical and/or fundamental analysis. Such price action can occur in any number of markets including stocks, bonds and commodities. The opposite price action is a selloff resulting from prices being overbought.
An oversold bounce implies that prices are correcting themselves upward because they went too low just prior to the bounce. Being oversold means that the price of an asset or market has fallen to a level below its fair value. Negative macroeconomic data such as employment figures or gross domestic product, GDP, misses can cause broad selloffs while company specific data such as poor corporate earnings or downward guidance can do the same to an individual stock.
How to Spot Oversold Conditions
The determination as to whether prices have fallen to a level that is oversold can be based on fundamental analysis or technical analysis. On the fundamental side, if prices have been sold down lower than book value or intrinsic value, there may be a strong case that it was oversold, or if the low price implies a price to earnings ratio, also known as a P/E ratio, that is suddenly much lower than its peers. With technical analysis, being oversold can be judged by looking at technical indicators. Prices that fall below a moving average, for example, might indicate the price is too low. Often times, indicators such as oscillators are employed to determine a potential lower bound that, if reached, would point to being oversold. The relative strength index, stochastic oscillator, MACD, or moving average convergence divergence measure, and money flow index are all used by market technicians.
When enough market participants deduce that the price of an asset is oversold, they are likely to enter that market as buyers to bid up that price to at least the equilibrium level it should be at based on technical measures or valuation models. Because many people may come to this conclusion at the same time and compete with each other to buy undervalued shares, prices tend to bounce up quite quickly. If there are many short sellers in an oversold market, the ensuing bounce may be even more pronounced as those shorts are forced to cover in a short squeeze. Being oversold is a subjective measure even though it has objective considerations. As such, not every "oversold" asset will experience such a bounce.