The stock market can be a very complex place. The lexicon used in the world of investing often requires experience to fully understand what they mean.
The term oversold when we’re talking about stocks is often used, but many might be unsure as to what this refers to.
At its most basic, oversold stocks refer to stocks that have been selling for a lower price and have potential to bounce back in value.
The thing is, this potential can last for a very long time – and may not even bounce back at all. Identifying oversold stocks and how they might work for you might not be a simple process.
To understand this further, we’ve written this helpful guide. We’ll look at what oversold stocks are, how they might work and some other handy tips which you may need to know.
Read on to learn more.
What Does Oversold Indicate?
Oversold stocks to a fundamental trader tells us that the asset has been trading for below its usual metrics.
There are many technical indicators that can help to identify the levels of oversold or overbought stocks. Fundamental indicators as we mentioned can also help when reading the usual value metrics.
Technical analysts will almost always be referring to indicator readings if they use the term oversold. The two approaches are common and both have their own advantages, but they use differing systems in order to determine if assets have been oversold.
Let’s look at the two in more detail.
When a stock is fundamentally oversold, this would tell us that investors claim the assets are being sold under their true or usual value.
There are plenty of reasons why this could happen, such as something that causes a negative outlook on the company in question, a lack of trust in the company, or a failing market or a failing industry in general.
To indicate the actual value of stock to begin with, we would usually look at the P/E ratio, which essentially involves traders and professional analysts examining the company’s publicly reported finances.
This may be through their earnings reports or through an estimated earnings report. If this P/E ratio drops under their usual average or to the bottom of its range, investors can typically call this stock undervalued.
Long term investors will see a massive value in this, as opportunities arise to purchase potentially valuable stock for a much lower price.
Of course, this would require very careful analysis though before diving right into it. Let’s say for example that a stock which normally reported a P/E ratio of between 10 and 15 now drops to 5.
If the company is still stable and strong, their stock may be oversold and this would present as a viable opportunity to other long term investors who expect a bounce back.
However, sometimes it could suggest the company is free falling and therefore would not be a good option for investment.
The other way to assess if a stock is oversold is by using technical indicators which will look at both the current price and the previous prices of the stock, without looking at other external and fundamental data.
One such indicator is the RSI. This is a way to measure the movement of a stock price over a given period, which is typically 14 days.
If we see a low RSI which is usually 30 or below, traders will typically refer to this stock as being oversold. This is because the RSI is suggesting to us that the stock is now trading for only a third of its price range.
As we mentioned earlier though, this isn’t to say that the stock will consistently be in this position, and it’s possible for an immediate bounce back. Traders in this instance may decide to hold off until the RSI rises again.
In other words, traders may leave this stock until they see an RSI raise above 30, as this will indicate that the price was oversold, but it is now once again rising in worth.
In order to see areas which have been oversold, some traders may use pricing channels. Bollinger Bands is an example of this.
The banding represents a stock’s deviation against the moving average. If this stock reaches the bottom band, it would indicate that the stock has been oversold.
What Is The Difference Between Oversold And Overbought?
If we say that a stock has been oversold, we’re saying that the stock is being traded for a lower portion of its recent price – usually basing this on recent fundamental data.
However, when a stock is overbought – it’s the polar opposite of this. This is a technical indicator of when an asset is trading above or higher than its recent price based on data.
It’s important that we note here if a stock is overbought, this is not an indicator to sell – you should just pay attention to what’s going on.
The Limits Of Oversold Readings
Much as we mentioned a moment ago, the readings of being oversold or overbought are wrongly taken by many investors that they should buy or sell.
Indeed, there can be a multitude of reasons why a stock’s price falls below its average. As we stated previously, reasons inclusive of a company or industry failing can cause this.
This would not be a good time to start buying stock. In other words, just because the oversold readings are indicating an opportunity – it does not necessarily mean that you should take up the opportunity.
The Bottom Line
Oversold stock refers to stock that is being traded below its usual average metrics – whereas overbought refers to the opposite.
Despite the potential for an opportunity with oversold stock, it is never guaranteed and you should always look very closely at every other area of data before making a decision.