What oversold means for stocks, with examples

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, so it does not mean that a price increase 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 past prices. Fundamentals can also be used to determine if an asset is potentially oversold and has deviated from its typical value metrics.

What does oversold mean to you?

Oversold to a fundamental trader means an asset is trading well below its typical value benchmarks. Technical analysts typically refer to an indicator reading when they call oversold. Both are valid approaches, although the two groups use different tools to determine whether an asset is oversold.

Fundamentally 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 about the company in question, a poor outlook for the company going forward, an unfavorable industry, or a declining overall market.

Traditionally, a common indicator of a share’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 falls to the bottom of its historical 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 investment.

For example, a stock that has historically had a P/E of 10 to 15, and is now trading at a P/E of five, may signal investors to take a closer look at the company. If the company is still strong, the stock may be oversold and a good buy candidate. Careful analysis is needed, however, as there may be good reasons why investors no longer like the company as much as they once did.

Technically oversold

Traders can also use technical indicators to spot oversold levels. A technical indicator only looks at the current price relative to past prices. It does not consider 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 strength behind price movements over a recent period, usually 14 days.

A low RSI, usually below 30, indicates to traders that a stock may be oversold. In essence, the indicator is saying that the price is trading in the bottom third of its recent price range. This is not to say that the price will bounce back immediately. Many traders wait for the indicator to start heading higher before buying, as oversold conditions can last a long time. For example, a trader can wait for the oversold RSI to move back above 30 before buying. This shows that the price is oversold but is now starting to rise.

Some traders use price channels such as 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 can be oversold. Again, traders usually wait until the price starts to rise again before buying.

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.

Arrows are placed on the RSI 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 stay lower for a time.

The oversold level of the P/E will vary by stock, as each stock has its own P/E range in which it tends to travel. For this stock, buying near a P/E of 10 typically offered a good buying opportunity as the price. up the road 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 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 part of its recent price range. Similarly, an overbought fundamental reading appears when the asset trades on the high side of its fundamental ratios. This does not mean that the asset should be sold. It’s just a warning to watch what’s going on.

Restrictions on the use of oversold readings

Oversold is mistakenly considered a buy signal by some traders. Instead, it’s more of a warning. This 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 does not mean that the asset should be bought. Many stocks that continue to fall look downright cheap. 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 can still be sold, even if it looks cheap based on historical standards.

Even if a stock or other asset is a good buy, it may 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 rising before buying based on the oversold signal.