What it means, how it works, example

What is an oversold bounce?

An oversold bounce is an increase in the prices of securities that occurs as a result of the sell-off that precedes it, which is considered too severe. This may be short-lived, as underlying fundamentals may still point to lower prices; however, the speed of the sale may have been too severe initially, causing the bounce.

The opposite price action of an oversold bounce would be a sell-off due to overbought prices.

Understand an oversold rejection

Before an oversold bounce, due to behavioral tendencies such as herd behavior, loss aversion, and the temptation to panic, prices may fall 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.

An oversold bounce implies that prices are correcting themselves upwards because they went too low just before 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 trigger broad sell-offs, while company-specific data such as weak corporate earnings or downward guidance can do the same to an individual stock.

How to spot oversold conditions

Determining whether prices have fallen to an oversold level can be based on fundamental analysis or technical analysis. On the fundamental side, if prices have sold below book value or intrinsic value, there may be a strong case that it is oversold, or if the low price implies a price-to-earnings (P/E) ratio that is suddenly much lower than its peers. Often an oversold condition will be motivated by fear.

With technical analysis, oversold can be assessed by looking at technical indicators. For example, prices that fall below a moving average may indicate that the price is too low. Often indicators such as oscillators are used to determine a potential lower limit which, if reached, indicates that it is oversold. The relative strength index (RSI), stochastic oscillator, moving average convergence divergence measure (MACD) and money flow index are all used by market technicians to spot oversold conditions.

When enough market participants conclude that the price of an asset is oversold, they are likely to enter that market as buyers to bid that price up to at least the equilibrium level it should be at, based on technical metrics or valuation models. Because many people can come to this conclusion at the same time and compete with each other to buy undervalued stocks, prices tend to jump up quite quickly.

If there are many short sellers in an oversold market, the subsequent bounce can be even more pronounced as those shorts are forced to cover in a short push. Being oversold is a subjective measure, even if it has objective considerations. As such, not every “oversold” asset will experience such a bounce.

Example of an oversold bounce

Company ABC’s stock is trading at a price of $100. In their latest quarterly earnings report, the company announced earnings per share (EPS) at $1.45. Analysts had estimated the EPS to be $1.51. This combined with the recent news that Company ABC will have to pay a $2 million court settlement has investors bearish on the stock. As a result, investors start selling. As other investors see the price of the stock drop as well as the news, they also start selling. In 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, especially compared to its book value, because they believe it is underpriced, or oversold. This combined with the fact that the company has cash reserves of $20 million, which makes the $2 million court settlement a non-issue, leads investors to buy the stock again, as the long-term outlook of the company remains strong. Investors quickly start buying the stock again, the price rises, other investors jump on the bandwagon, and the stock experiences an oversold bounce.