What is overselling?
The term oversold refers to a condition in which an asset has traded at a lower price and has the potential to rebound. An oversold condition can last for a long time and, therefore, overselling does not mean that a price rise will happen soon, or not at all. Numerous technical indicators identify the levels of oversold and overbought. These indicators base their assessment on where the price is currently trading compared to previous prices. Fundamentals can also be used to assess whether an asset is potentially oversold and has deviated from its typical value parameters.
Key points to remember
- Oversold is a subjective term. Since traders and analysts all use different tools, some may see an oversold asset while others see an asset that has yet to fall.
- The oversold conditions can last for a long time, so cautious traders wait for the price to base and start to go up before buying.
- The oversold conditions are identified by technical indicators such as the relative strength index (RSI) and the stochastic oscillator, as well as others.
- The fundamentals can also highlight an oversold asset by comparing current values to previous values in terms of price / profit (P / E) and P / E futures, for example.
What does Oversold tell you?
Overselling a fundamental trader means an asset that they trade well below their typical value parameters. Technical analysts generally refer to an indicator reading when they mention an oversold. Both are valid approaches, although the two groups use different tools to determine if an asset is oversold.
Basically oversold stocks (or any asset) are those which investors believe are trading below their actual value. This could be the result of bad news about the company in question, bad prospects for the company in the future, a poor industry or a slump in the overall market.
Traditionally, a common indicator of a stock’s value has been the P / E ratio. Analysts and traders use published financial results or profit estimates to identify the appropriate price for a particular stock. If the P / E of a security drops to the bottom of its historical range, or falls below the average P / E of the sector, investors can see the security as undervalued. This can present a buying opportunity for a 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 encourage investors to take a closer look at the company. If the business is still strong, the stock can be oversold and a good buy candidate. Careful analysis is required, however, as there may be good reasons why investors no longer love the business as much as they once did.
Traders can also use technical indicators to establish oversold levels. A technical indicator only looks at the current price compared to previous prices. It does not take into account the fundamental data.
George Lane’s stochastic oscillator, which he developed in the 1950s, examines recent price movements to identify changes in the momentum and direction of a stock’s prices. The RSI measures the power behind price movements over a recent period, usually 14 days.
A low RSI, usually below 30, signals to traders that an action may be oversold. The indicator essentially indicates that the price is trading in the lower third of its recent price range. This does not mean that the price will rebound immediately. Many traders wait for the indicator to start moving up before buying, as the oversold conditions can last for a long time. For example, a trader may wait for the oversold RSI to return above 30 before buying. This shows that the price has been oversold but is now starting to rise.
Some traders use pricing channels like Bollinger Bands to identify oversold areas. On a graph, Bollinger bands are positioned at a multiple of the standard deviation of an action 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 before buying.
What does overselling mean?
Examples of overselling indicators and principles
The sample graph shows a price graph with two indicators below it. The upper indicator is an RSI, and the one below is P / E.
On the RSI, arrows were placed where the RSI fell below 30 and then returned above. These would be possible points of purchase based on the recovery of an oversold condition. Some of these signals caused the price to go up, while others saw the price go down for a while.
The P / E oversold level will vary depending on the 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 generally presented a good buying opportunity because the price directed higher from there.
The difference between oversold and overbought
If overselling occurs when an asset is trading at the bottom of its recent price range or trading near the lowest on the fundamental data, overbought is the opposite. An overbought technical indicator appears when the price of an asset is trading at the top of its recent price range. Similarly, an overbought fundamental reading appears when the asset is trading at the upper end of its fundamental ratios. This does not mean that the asset must be sold. This is just an alert to see what’s going on.
Limits on the use of oversold statements
Oversold is mistakenly viewed by some traders as a buy signal. Rather, it is an alert. It lets traders know that an asset is trading in the lower part of its recent price range, or is trading at a fundamental ratio lower than what it usually does. This does not mean that the asset must be purchased. Many stocks that continue to fall seem cheap all the way down. This can happen because most oversold readings are based on past performance. If investors see a bleak future for a stock or other asset, it can continue to be sold even if it looks cheap by historical standards.
Even if a stock or other asset is a good buy, it can remain oversold for a long time before the price starts to go up. This is why many traders monitor oversold readings, but then wait for the price to start rising before buying based on the oversold signal.