Summary - One of the key drivers of market economies is the principle of supply and demand. For investors and traders, this see-saw battle can produce inequality in pricing. At any given time, an asset or even an entire class of equities may experience a sell-off that is disproportionate to current economic conditions, causing it to be priced at less than its perceived intrinsic value. When this happens, an asset - such as a stock – will be reported to be in an oversold condition.
An oversold condition is a short term signal that suggests an asset may be ready to see its price increase. If the signal is accurate, investors and traders can profit by buying the asset at a discount to the market and generating profit as it increases. By categorizing an asset as oversold, analysts are not making a long term buying recommendation. They are simply pointing out an inequality that is available for savvy traders to further research.
There are many ways for investors to determine, or confirm if an asset is oversold. Fundamental analysts will look at a company’s price-to-earnings (P/E) ratio in comparison to other companies within that sector or industry. They will also look at earnings reports that help describe the inner workings of a company including a review of their balance sheet for capital flows and debt levels. Technical analysts will look at the Relative Strength Index (RSI) and combine that with other technical indicators that will help them confirm an oversold condition. Many trading platforms include tools such as a stock screener that can help identify stocks and other equities that are defined as being oversold.
One of the limitations setting up an investment strategy based on an oversold condition is that an asset can remain oversold for quite some time. Market sentiment is often emotional and a stock can continue to go lower even if other indicators suggest an asset is undervalued. Part of the reason for this is that two analysts may have different methodologies for determining when an asset is oversold.
The opposite of an oversold condition is an asset that is overbought. In this case, an asset has seen its price rise above what analysts perceive as its intrinsic value. When this happens, the implication is that a sell-off is likely. As with oversold assets, an asset that is labeled overbought is not necessarily a bad investment, it is just ripe for profit-taking.
Introduction
One of the keys to successful investing is the ability to distinguish between price and value. In some cases, investors will begin to sell a stock or security after there has been bad news. In the case of shares of stock that bad news may take the form of a negative earnings report or failure to meet regulatory approval. In the case of other equities, there may be negative economic indicators that show evidence of a slowing economic growth such as a declining labor market. When this price movement causes these assets to move below their typical averages it can cause a stock to be considered oversold. In this article, we’ll focus on a security that is oversold. We’ll define oversold assets and describe the conditions that can lead to an asset becoming oversold. The article will also take a closer look at how analysts use fundamental or technical indicators to confirm an oversold condition and the limitations that can come from an oversold condition.
What defines an oversold asset?
An asset is considered to be oversold when it is trading at a price that is lower than its perceived intrinsic value. This means that, in the eyes of analysts, the asset has the potential to rise in price.
The opposite of a stock being oversold is a stock that is overbought. An overbought stock is a stock that is trading at a premium to its intrinsic value. The classification of oversold or overbought is a snapshot of the volume between buyers and sellers. It is up to individual investors to determine why, in the case of an oversold asset, sellers outnumber buyers.
One of the common ways to notice overbought or oversold conditions is by looking for support and resistance levels. Support levels indicate a low price level that a stock does not move below. A resistance level is a price level that a stock does not move above.
How does a security become oversold?
Any asset class can become oversold. In fact, there are times when a whole stock market index, such as the S&P 500 may be considered to be oversold. Many times an oversold market is based more on an emotional response to systemic concerns. For example, a fear of rising interest rates may generate movement in the forex market as other currencies become oversold compared to the U.S. dollar. Simultaneously, oil prices may fall as investors fear that rising interest rates will slow down economic growth. These are examples of how investors can be dealing with oversold conditions in any asset class. However overbought and oversold are terms frequently discussed in terms of individual stocks.
For every stock, there are only so many outstanding shares available for public trading. A stock becomes oversold when there are more sellers than buyers in a compressed time frame. Bad news about a stock can cause the shares to experience rapid price movement below its intrinsic value. As we stated earlier, when analysts declare that a stock is oversold it does not mean that the stock will rise. It is a notion of value. The existence of an oversold condition should be taken as only one piece of investment advice.
How do analysts define an oversold condition?
Analysts use both fundamental and technical indicators to determine when an asset, such as a stock, is oversold. Fundamental indicators include news items and events that may affect an asset's performance. For example, if a company misses on the top line and/or bottom line of their quarterly earnings report, it may trigger a sell-off for their stock. If the sell-off leads to a state of panicked selling, a stock that is otherwise very reasonably priced may soon move into an oversold condition. Another fundamental indicator that is part of a company’s earnings report is their balance sheet. If the company is showing such things as a high debt level it could be a sign that the company will have lower expectations for growth going forward. Other macroeconomic data for fundamental analysis includes a review of economic indicators. Every month these indicators give a snapshot of different aspects of the broader economy including consumer confidence, unemployment, the Producer Price Index (PPI) and Consumer Price Index (CPI). One of the key fundamental indicators that stock investors will look at is a company’s price-to-earnings (P/E) ratio. In doing so, investors are not looking for a specific number but rather how a particular company’s P/E ratio stacks up against other companies in its sector or against other companies with a similar market cap. If the stock’s P/E ratio is significantly lower than others in its sector, it can be a sign that a stock is oversold.
Technical analysts set up their trading strategies based on the presumption that the stock market has digested all the news that can be gleaned from fundamental analysis and has already factored that into an asset's price. They look for specific technical indicators to confirm future price movement that they can then use in a trade setup. Many trading platforms include an oversold stocks screener tool. These tools are proprietary to the trading software, but it can be a useful starting point for traders who are looking to get a broad overview of potential trading targets. Keep in mind different software platforms may use different technical signals to determine an overbought or oversold condition.
One of the most common technical indicators is the Relative Strength Index (RSI). The RSI is a measure of volatility and expresses a ratio of the average upward movement to the average downward movement over a specific period of time, typically 14 days. It is not a measure of price movement, but rather how committed buyers and sellers are to their positions.
An RSI below 30 is seen as an oversold, or bullish, indicator. Conversely, an RSI reading above 70 indicates an overbought or bearish indicator. The RSI is a reflection of supply and demand. When a stock is exhibiting undersold conditions, the RSI will stay below 30 and only occasionally rise to 70. This is because if a security is in a downtrend, sellers will outnumber buyers meaning the index should show more lows than highs. When a security is in an uptrend, the RSI will tend to stay above 30 and should frequently rise to 70 or above. This is because when a stock is overbought buyers outnumber sellers so traders would expect a security to show more gains than losses.
Traders use charting software to overlay the RSI, along with other technical indicators, on a daily chart. Other technical indicators that traders use in conjunction with the RSI to identify overbought/oversold conditions include:
- Candlestick Patterns– Displaying a daily chart using a candlestick pattern tells traders a story of price movement by both the shape and shading of the candle. Because they are useful in identifying potential changes in market direction, accurate interpretation of a candlestick pattern can provide confirmation for an RSI level.
- Bollinger Bands– these are bands that are plotted one standard deviation above and one standard deviation below a security’s exponential moving average. A security that is selling near the low end of the lower Bollinger band and has a low RSI is usually considered oversold.
- Fibonacci Retracement Levels– A Fibonacci retracement level is identified by taking an extreme high and low on a stock chart and dividing the distance between the two (visually this will be the vertical distance) by the key Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, and 100%). These levels will then be defined on a chart by horizontal lines that indicate potential areas of support and resistance. It is unclear why the Fibonacci ratios are such a consistent predictor of stock price movement only that they are.
- Moving Average Convergence/Divergence Oscillator (MACD)– The moving average convergence/ divergence oscillator shows the relationship between two exponential moving averages (EMAs). The most common moving averages used are the 26-day moving average as the longer average and the 12-day moving average as the shorter average. By subtracting the longer average from the shorter average, the MACD displays both the trend of the price action for the underlying security as well as the momentum of buying and selling activity. The companion to the MACD line is a signal line which is the 9-day EMA for the asset being used. The MACD is a momentum oscillator that moves above or below a center line (also called a zero line). Traders will look for signal line crossovers, centerline crossovers, and divergences between the MACD line as triggers for buying (bullish divergence) and selling (bearish divergence).
Limitations of trading oversold assets
An asset that is an oversold state can stay that way for a long time. So traders who are anticipating an immediate price bounce may be disappointed. Also, investor sentiment is not always rational which means that an asset that is oversold may continue to decline in price. Also, the definition of oversold is based on subjective analysis, meaning some analysts may still see the price of a stock as having room to fall while others may say a stock is oversold.
The final word on oversold assets
When an asset is categorized as oversold, analysts are referring to a condition where sellers have outnumbered buyers to the extent that the price of the asset has gone too far in a negative direction and both fundamental and technical indicators are suggesting that the stock is now trading at a discount to comparable stocks. When confirmed with other trading signals, an oversold stock can be a buying signal. The opposite of a security being oversold is one that is overbought. This indicates a security that is displaying indications that its price is trading at a premium to its intrinsic value.
An oversold asset is not necessarily ready to overperform, but rather it is a way for analysts to define the current state of supply and demand. Analysts seek to find the sweet spot between price (which is the dollar amount investors pay for a security) and value (what that security is actually worth).
To determine an oversold condition, investors who practice fundamental analysis will look at the price-to-earnings (P/E) ratio which provides a side-by-side comparison of two comparable stocks (same sector, market cap, etc.). Traders, particularly day traders, will look at technical indicators to help them define their trading strategies. One of the most common indicators is the Relative Strength Index (RSI) which helps to show the momentum and volatility surrounding price movement. When the RSI is used with other technical indicators it can provide further confirmation of oversold conditions. The indication of an oversold condition does not mean the stock is certain to rise in price. Stocks can rise and/or fall for reasons that defy market expectations.
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