What is Oversold
Oversold is a widely used term that refers to a security that traders and analysts believe is trading below its true value. The term generally describes a short-term movement in the stock’s price rather than a long-term condition.
What Does Oversold Mean?
BREAKING DOWN Oversold
Oversold stocks are those that analysts feel are trading below their true value. This can be the result of bad news regarding the company in question, its industry or the overall market. Whatever the case, the oversold stock has fallen victim to an overreaction among investors and the supply of shares has exceeded demand. Investors commonly hold the misperception that this only happens to smaller, lesser-known companies. Research has shown that large-cap stocks are also subject to overselling but tend to recover more quickly than their smaller counterparts.
Traditionally, the standard indicator of a stock’s value has been the price-earnings ratio (P/E). Analysts and companies have used either publicly reported results or earnings estimates to identify the appropriate price for a particular stock. If a stock’s P/E dips below that of its sector or a relevant index, investors may see it as undervalued and as a smart buying opportunity for long-term investing. The rise of technical analysis has allowed traders to focus on indicators of a stock that they consider undervalued on a much narrower time frame. Traders refer to such a security as undersold.
Technical Analysis Tools for Identifying Oversold Stocks
Technical analysis has provided traders with increasingly sophisticated tools to identify oversold stocks. George Lane’s stochastic oscillator, which he developed in the 1950s, examined recent price movements to identify imminent changes in a stock’s momentum and pricing trend. This laid the foundation for the technical indicator which has become the primary indicator of an oversold stock, the relative strength index (RSI). The RSI measures the power behind price movements over a recent period, typically 14 days, using the following formula:
RSI = 100 - 100/(1 + RS)
RS represents the ratio of average upward movement to downward movement over a specified period of time. A low RSI, generally below 30, signals traders that a stock may be oversold and that the market should correct with upward pressure in the near term. Many traders use pricing channels like Bollinger Bands to confirm the signal that the RSI generates. On a chart, Bollinger Bands lie one standard deviation above and below the exponential moving average of a stock’s recent price. Analysts that identify a stock with a low RSI and a price that is edging toward the low end of its downward Bollinger Band will likely consider it to be oversold.