Oversold

Updated on May 3, 2024
Article byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

Oversold Meaning

Oversold stocks are undervalued. Therefore, an impending price bounce is highly likely. When a particular market instrument is sold continuously, investors think the asset’s price has hit rock bottom—the asset becomes oversold.

This scenario signals the end of short-term declines and the beginning of an upward rally. Investors often look for oversold stocks to buy low and sell high. An overbought market is the polar opposite, the stock price is about to decline.

Key Takeaways

  • Oversold is a market condition where an asset is trading below its actual price with a huge potential for price bounce.
  • Technical indicators like RSI, stochastic oscillator, and on-balance volume help traders identify undervalued assets.
  • This scenario supports a bullish rally and lets investors make good profits.

Oversold

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Oversold Explained

An oversold asset is undervalued. It is a market environment where all analysis, reports, sentiment, and indicators point towards a stock being priced below its actual market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more. Investors see it as a green signal to make a purchase. Asset prices cannot be one-directional for long. Sooner or later, the trend reverses. Investors try to purchase right before this happens.

Oversold chart

(Source)

It is a strategy where undervalued assets are identified in a bullish environment. Traders try to predict, when the price increase will appear (price bounce). Valuation indicators enable traders to buy at a lower price and then sell high—registering higher profits. Identifying such markets, though, is a challenging task, even for advanced traders.

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Oversold Indicators

#1 – Stochastic Oscillator

This is the most commonly used indicator. When the oscillator is applied to a chart, the indicator outputs a line with values ranging between 0 and 100. The investor interprets it as follows—for oversold scenarios, the range is between 0 and 20—for overbought scenarios, it varies between 80 and 100.

It signals an upcoming price reversal (bullish). That would be the right moment to purchase. But the investor must understand that the indicator can remain constant for a long time. It does not determine the exact time of price reversal.

#2 – Relative Strength Index (RSI)

It is similar to the Stochastic Oscillator—RSI also gives importance to price momentum. But RSI doesn’t rely on a simple moving averageMoving AverageMoving Average (MA), commonly used in capital markets, can be defined as a succession of mean that is derived from a successive period of numbers or values and the same would be calculated continually as the new data is available. This can be lagging or trend-following indicator as this would be based on previous numbers.read more as a second line.

The stocks are considered oversold when the RSI indicator floats below the 30 mark. So, investors sell when the value rises over 70 and starts falling. Similarly, investors buy when values fall below 30 and start rising.

It is important to note that RSI is not a universal indicator—it is prone to false positives, known as failure swings.

#3 – Bollinger Bands

Using Bollinger Bands is simpler when compared to other indicators. It is a pricing channel comprising three lines that use the 20-day SMA.

To obtain the 20-day Simple Moving AverageSimple Moving AverageSimple moving average refers to a type of moving average, and it is derived by calculating the average of prices or values observed over a specific number of days or periods.read more (SMA), the closing prices for the previous 20 trading days are added and then divided by 20,

Bollinger Bands are easy to comprehend—when the price breaks the upper line, a bearish market is indicated. Similarly, when the price breaks the lower line, a bullish market is indicated—investors may expect a rally making it the right moment to buy.

#4 – Commodity Channel Index (CCI)

This index compares the instrument’s current price fluctuations with its past prices. Though it is called the Commodity Channel Index, it can be applied everywhere—assets, stocks, FX, etc.

The indicator reduces the uncertainty caused by cyclical and seasonal markets—a powerful tool for predicting upcoming trend reversals.

#5 – Parabolic SAR

The Parabolic SAR monitors price changes and price variation speed. SAR stands for “stop and reverse.” The word “parabolic” refers to the indicator’s calculations—they resemble a parabola.

Only advanced traders use the Parabolic SAR. Comprehending this indicator takes time. This indicator is used to gauge the market’s overall state.

#6 – Fibonacci Retracement

The Fibonacci RetracementFibonacci RetracementThe Fibonacci retracement is a trading chart pattern that traders use to identify trading levels and the range at which an asset price will rebound or reverse. The reversal may be upward or downward and can be determined using the Fibonacci trading ratio. read more ranks among the most popular technical indicatorsTechnical IndicatorsTechnical indicators refer to technical analysis tools used by investors to make investment decisions based on future price movements derived primarily from historical prices. read more. The indicator is based on the Dow Theory of Retracement—once an initial price movement occurs, the price will eventually retrace near 50% (Fibonacci retracement levels are between 38.2% to 61.8%).

Oversold - Fibonacci Retracement

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Fibonacci Retracement tracks whether a resistance line is present. If the price constantly fails to overcome the resistance line, the trader considers the stock oversold.

The resistance line is the level at which stock prices start falling—due to selling pressure.

#6 – On-Balance Volume (OBV)

It is a volume-based momentum indicator. It forecasts bullish and bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more reversals by reflecting the investors’ sentiment and gauging the buying and selling pressure.

On-Balance VolumeOn-Balance VolumeThe On-Balance Volume (OBV) is a technical indicator that reflects the buying or selling pressure of a stock.read more suggests that a price change will always follow an increase in trading volume.

#7 – Moving Average Convergence Divergence (MACD)

MACD measures both market momentum and market trend. The indicator measures the intensity of an upward or downward trend. If the MACD line dives above the signal line, the trend is bullish—traders are safe to buy a security. Similarly, it indicates a bearish trend when it dives below the signal line.

MACD is not reliable. Investors should use the RSI or Stochastic Oscillator to confirm MACD’s results.

Example

An oversold bounce in the Nasdaq 100 is poised to develop following a 15% decline. A key support area for the tech-heavy index is 14,400—a natural slot for an oversold bounce to unfold. Recently, the Nasdaq 100 fell approximately 3%—just below14,000.

The sentiments of depressed investors fuel such a bounce—suggesting a minor low. Since October 2020, short-term oversold conditions have been the most widespread.

Instead of buying stocks, investors are advised to use this as an opportunity to reduce exposure to equitiesEquitiesEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more.

All this points to a volatile trading environment in 2022—identical to the 2018 environment. The share marketShare MarketThe share market is a public exchange where one can buy and sell company shares based on the demand and supply of shares. read more has witnessed volatility in 2021 as well; S&P 500 declined by 5% and ended at a 27% gain.

Overbought vs Oversold

Frequently Asked Questions (FAQs)

How to find oversold stocks?

Technical indicators are applied to charts to obtain price swings. The following technical indicators are used:
1. RSI
2. Moving Average Convergence Divergence (MACD)
3. On-Balance Volume
4. Stochastic Oscillator
5. Parabolic SAR

Are oversold assets good to buy?

Yes, these stocks offer investors profitable opportunities. Such stocks are undervalued; after the price bounce, they can be sold at a profit.

Do oversold stocks bounce back?

Certain conditions fuel a bounce back: prices tend to bounce back rapidly when many investors identify the same undervalued stock. If there are many short sellers, the bounce will become more pronounced.

This has been a guide to what is Oversold and its meaning. Here we discuss oversold stocks, indicators, and examples. You may learn more about financing from the following articles –