What Is an Oversold Bounce?
An oversold bounce is a rally in the prices of securities that occurs due to the selloff preceding it being perceived as too severe.
- An oversold bounce refers to a rally in the price of a security after a selloff that is perceived as too severe.
- During an oversold bounce, the price of a security quickly goes up to a level in line with its valuation.
- The price of an asset can fall drastically due to herd behavior, aversion to loss, panic, as well as because of negative news related to the security or market.
- An oversold security is one whose price is below its book value or intrinsic value.
- Technical analysis and fundamental analysis can be used to determine whether or not a security is oversold.
Understanding an Oversold Bounce
Before an oversold bounce, due to behavioral tendencies such as herd 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) missing their estimates can cause broad selloffs while company-specific data such as poor corporate earnings or downward guidance can do the same to an individual stock.
An oversold bounce occurs when investors start purchasing more and more of a security they perceive is priced too low, causing a rapid increase in the price of that security.
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 the 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 (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. Oftentimes, 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, moving average convergence divergence measure (MACD), 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.
Example of an Oversold Bounce
Company ABC's stock trades at a price of $100. In their latest quarterly earnings report, the company announced earnings per share (EPS) at $1.45. Analysts had estimated that the EPS would be $1.51. This combined with the recent news that Company ABC will have to pay a court settlement of $2 million causes investors to be bearish on the stock. As a result, investors start selling. As other investors notice the price of the stock falling as well as the news, they start to sell too. Over one month, the price of Company ABC's stock goes from $100 to $85.
After this month, investors realize that the stock has fallen rapidly, particularly when compared to its book value, believing it is underpriced, or oversold. This combined with the fact that the company has cash reserves of $20 million, making the $2 million court settlement not a large issue, results in investors buying the stock again, as the long-term prospect of the company remains healthy. Investors start quickly buying the stock again, the price increases, other investors jump on the bandwagon, and the stock experiences an oversold bounce.