What is Oversold?
The term oversold refers to a condition where an asset has traded lower in price and has the potential for a price bounce. An oversold condition can last for a long time, and therefore being oversold doesn't mean a price rally will come soon, or at all. Many technical indicators identify oversold and overbought levels. These indicators base their assessment on where the price is currently trading relative to prior prices. Fundamentals can also be used to assess whether an asset is potentially oversold and has deviated from its typical value metrics.
- Oversold is a subjective term. Since traders and analysts all use different tools, some may see an oversold asset while others see an asset that has further to fall.
- Oversold conditions can last for a long time. Therefore, an asset becoming oversold is not an immediate buy signal. Prudent traders wait for the price to base out and start to move higher before buying.
- Oversold conditions are identified by technical indicators such as the relative strength index (RSI) and stochastic oscillator, as well as others.
- Fundamentals can also highlight an oversold asset by comparing current values to prior values in terms of price/earnings (P/E) and forward P/E, for example.
What Does Oversold Tell You?
Oversold to a fundamental trader means an asset it trading well below its typical value metrics. Technical analysts are typically referring to an indicator reading when they mention oversold. Both are valid approaches, although the two groups are using different tools to determine whether an asset is oversold.
Fundamentally oversold stocks (or any asset) are those that investors feel are trading below their true value. This could be the result of bad news regarding the company in question, a poor outlook for the company going forward, an out of favor industry, or a sagging overall market.
Traditionally, a common indicator of a stock’s value has been the P/E ratio. Analysts and traders use publicly reported financial results or earnings estimates to identify the appropriate price for a particular stock. If a stock’s P/E dips to the bottom of its historic range, or falls below the average P/E of the sector, investors may see the stock as undervalued. This may present a buying opportunity for long-term investing.
For example, a stock that has historically had a P/E of 10 to 15, and which is now trading at a P/E of five may signal investors to look closer at the company. If the company is still strong the stock may be oversold and a good buy candidate. Careful analysis is needed though, as there could be good reasons why investors no longer like the company as much as they once did.
Traders can also use technical indicators to establish oversold levels. A technical indicator only looks at the current price relative to prior prices. It does not take into account fundamental data.
George Lane’s stochastic oscillator, which he developed in the 1950s, examines recent price movements to identify changes in a stock’s momentum and price direction. The RSI measures the power behind price movements over a recent period, typically 14 days.
A low RSI, generally below 30, signals traders that a stock may be oversold. Essentially the indicator is saying that the price is trading in the lower third of its recent price range. This isn't to say the price will bounce immediately. Many traders wait for the indicator to start heading higher before buying since oversold conditions can last a long time. For example, a trader may wait for the oversold RSI to move back above 30 before buying. This shows that the price was oversold but is now starting to rise.
Some traders use pricing channels like Bollinger Bands to spot oversold areas. On a chart, Bollinger Bands are positioned at a multiple of a stock's standard deviation above and below an exponential moving average. When the price reaches the lower band, it may be oversold. Once again, traders typically wait until the price starts rising again before buying.
What Does Oversold Mean?
Examples of Oversold Indicators and Fundamentals
The chart example shows a price chart with two indicators below it. Top indicator is an RSI, and the one below it is P/E.
On the RSI, arrows have been placed where the RSI dropped below 30 and then moved back above it. These would be possible buy points based on recovery from an oversold condition. Some of these signals resulted in the price going higher, while others saw the price continue lower for a time.
The oversold level of the P/E will vary by stock, since each stock has its own P/E range it tends to travel in. For this stock, buying near a P/E of 10 typically presented a good buying opportunity as the price headed higher from there.
The Difference Between Oversold and Overbought
If oversold is when an asset is trading in the lower portion of its recent price range or is trading near lows based on fundamental data, then overbought is the opposite. An overbought technical indicator reading appears when the price of an asset is trading in the upper portion of its recent price range. Similarly, an overbought fundamental reading appears when the asset is trading at the high end of its fundamental ratios. This doesn't mean the asset should be sold. It is just an alert to look into what is going on.
Limitations of Using Oversold Readings
Oversold is mistakenly viewed by some traders as a buy signal. Instead, it is more of an alert. It lets traders know that an asset is trading in the lower portion of its recent price range, or is trading at a lower fundamental ratio than it typically does. This doesn't mean the asset should be bought. Many stocks that continue to fall look cheap all the way down. This can happen because most oversold readings are based on past performance. If investors see a grim future for a stock or other asset, it may continue to be sold off even though it looks cheap based on historical standards.
Even if a stock or other asset is a good buy, it can remain oversold for a long time before the price starts to move higher. This is why many traders watch for oversold readings, but then wait for the price to start moving up before buying based on the oversold signal.