DEFINITION of 'Oversold'
Oversold is a condition in which the price of an underlying asset has fallen sharply to a level below where its true value resides. This condition is usually a result of market overreaction or panic selling and is generally considered short term in nature. When an asset has been oversold, the price is expected to rebound in an event referred to as a price bounce.
BREAKING DOWN 'Oversold'
An oversold asset is often considered to have a selling price that is too low in comparison to the actual value of the asset. This can be based on certain metrics including the current price-to-earnings (P/E) ratio. For example, the Dow Industrial had a P/E ratio of 19.07 on July 1, 2016.
If a particular stock had a P/E ratio below 19.07 while other stocks from the same industry were above 19.07, the first stock may be considered oversold. This belief may be strengthened if the stock also shows higher-than-average earnings or growth when compared to others in its sector.
Typically, securities oversell due to an overreaction on the part of investors regarding a piece of news or other information. Once buying or selling begins to increase, that activity spurs more of the same. Prices for the security shift according to the direction of the market movement, with buying leading to higher prices and selling resulting in lower ones.
Analyzing Oversold Assets
Assets that have experienced sharp declines over a brief period of time are often deemed to be oversold. Determining the degree to which an asset is oversold is very subjective and could easily differ between investors. In a technical analysis, when the price of an asset has fallen to such a degree that an oscillator has reached the lower bound, the asset is generally considered undervalued. As the price has fallen, this may represent a buying opportunity for investors as the current lower pricing may rebound, resulting in relatively swift gains.
Identifying areas where the price of an underlying asset has been unjustifiably pushed to extremely low levels is the main goal of many technical indicators such as the relative strength index, the stochastic oscillator, the moving average convergence divergence and the money flow index. This allows investors to purchase securities at below-actual-value prices and potentially sets up for a quick return should the market correct as expected.
Oversold and Overbought
Oversold is the opposite to overbought. With an oversold asset, the price decreases as more investors look to sell the asset to remove it from their portfolios. Overbought assets occur when the market experiences a sudden, significant rise in the buying of a particular security. This drives prices up substantially over a short period of time and leads to the asset being overvalued until the market corrects.