Oversold Market – 8 Things to Consider Before Trading

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What does 'Oversold' mean

The term oversold and overbought are two of the most commonly used terms in the financial markets. Depending on what and how it is being references, there can be two distinctive meanings.

In the first type, an oversold condition exists when the value of the security or the asset falls rapidly below its market value.

In the second type, an oversold condition occurs when an indicator that is used to analyze a security falls to an extreme level.

The process of a security being oversold or overbought occurs periodically and can be considered as a correction, that the price of a security undergoes. Sometimes the oversold conditions can be short with price resuming the previous uptrend quickly and at times, the oversold conditions can be prolonged.

1 - Oversold market in Fundamental analysis

The oversold market condition is said to exist when the price of the security or the underlying asset is trading below the true value. The oversold conditions exist for several reasons.

Most commonly, it can occur when the market reaction is extreme to a certain news or event that affects the price of the security in question. Oversold levels can exist either for a short time or for a very long time.

Attempting to determine a bottom in the market during the oversold process can be difficult and is often risky for the investor. The overselling can come in either a steep decline or in bouts of selling in which case one can expect the security’s price to keep bouncing every now and then.

When a security is oversold in the markets, there can be a good buying opportunity especially if the intrinsic business value still holds. This oversold market conditions finally can lead to picking stocks at a discount.

Overselling occurs either during a broader market slump or on a specific news or event that hits a certain sector in which case, almost all stocks or securities in the sector can take a hit.

2 - Understanding the oversold market condition in fundamental analysis

Fundamentally, an oversold asset or security is defined as one whose selling price is too low, compared to the actual value of the asset in question. There can be several ways to determine the metrics, which also makes it a bit complex in understanding how much a stock or a security is oversold.

Generally, the simplest of metrics to use can be the price-to-earnings or P/E ratio. The P/E ratio is a ratio between the price of a company's stock to its earnings per share.

The P/E ratio is widely used as a valuation metric. Of course, there are a lot more metrics besides just the P/E when it comes to stock valuation or in understanding if a stock is oversold.

The P/E is although widely used as a metric to compare stocks within a sector. So for example, if the price earnings ratio in a sector was 20 but a few stocks have a price to earnings evaluation of below 20, that stock or security can be considered to be oversold.

Of course, determining whether the security or an asset is oversold is not as simple as that. Investors will need to look at other metrics as well. This includes considering metrics such as average earnings and growth potential.

Taking the above factors into consideration, an investor can decide whether the stock is indeed oversold and if it is trading at a discount to its intrinsic value.

A security or a stock can be oversold for many reasons. It could be the most basic such as portfolio rebalancing or simply offloading a stock for a purpose. In most cases, overselling is usually triggered by some news or information that can worsen investor sentiment.

3 - How to analyze oversold stocks?

A stock's price that has fallen significantly over a period can be said to be oversold. Sometimes, the depth of overselling can be moderate and at times it can be extreme. There is no way of telling on how sharp the selling can be.

Furthermore, it is also quite complex to determine the degree of overselling. Given the fact that it is highly subjective, you can expect to hear differing opinions on the same stock.

One of the common misconceptions is that a stock that is oversold will bounce back. While that may be true, the level of the bounce can be moderate or small in comparison to the broader selling.

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Taking a counter trend (long) position when a stock is being oversold can be disastrous and could quickly lead to mounting losses if the trade is not managed correctly.

Emotions also plays a big role in trying to determine the degree of overselling in the stock. It is not difficult to find investors caught in a bad position when the stock is being heavily oversold. There is a chance that the overselling could subside and the price will recover quickly.

4 - Oversold market in Technical analysis

In technical analysis, an oversold market is when a technical indicator (usually an oscillator) dips below a level that is determined to be an oversold level. Based on the technical indicator being used, the oversold level can vary.

For example, a Stochastics oscillator as a value of 20 as the lower threshold. When the indicator's value dips below 20 the security is said to be oversold. On the other hand, when the Relative Strength Index (RSI) dips below 30, the security is said to be oversold.

Therefore, the meaning of oversold in technical analysis is also a bit subjective depending on which indicator is being referenced.

5 - How to analyze oversold stocks with technical analysis?

A security’s price continuously keeps moving from overbought to oversold levels, which also brings to point an important aspect of using the term oversold in technical analysis.

For one, a stock can be oversold based on the indicator but in an uptrend. On the other hand, a stock can also be oversold in a downtrend.

The chart below demonstrates the oversold levels in a security’s price based on the 14 period RSI. The RSI is the most commonly used technical indicator in determining oversold levels and is usually found in several technical stock screeners.

Below you can find an example of a sample stock screener (Finviz) where stocks that are oversold are shown. Here, the criterion is for the RSI (14) being oversold or below 20.

Finviz Technical Stock Screener showing stocks that are oversold based on RSI values

Finviz Technical Stock Screener showing stocks that are oversold based on RSI values

The chart below shows the price chart for one of the stocks picked from the filter, Chicos FAS Inc (CHS). On the chart, is the 14 period RSI technical indicator as well which shows that the stock is deemed to be oversold as the indicator dips below 20.

Chicos FAS Inc, (CHS) Stock chart with RSI (14)

Chicos FAS Inc, (CHS) Stock chart with RSI (14)

Some stock traders prefer to use the oversold levels alongside other methods to pick the bottoms in the price. While this can offer some good gains as seen in the above chart, it is equally risky as at times, the selloff can be intense.

6 - Oversold does not mean a bounce

One of the common misconceptions in technical analysis is that traders tend to think that when a stock is oversold, it will bounce back. This may or may not be true all the time and it depends on the stock in question and the price action itself.

Generally, if the momentum is strong, a stock can remain heavily oversold for a prolonged period with no telling for how long the price will continue to fall. The oscillator on the other hand continues to steadily decline in the process.

Hoping to catch a bottom in such cases can be risky as the stock is likely to remain bearish.

The chart below shows how the stock prices continues to decline with each of the subsequent oversold levels showing lower lows forming in price.

Example of Tootsie Roll Industries (TF) in a downtrend and the RSI’s oversold levels

Example of Tootsie Roll Industries (TF) in a downtrend and the RSI’s oversold levels

Another classic example is the next chart, which is the SPDR Gold shares (GLD) ETF. In this next chart, you can see that the RSI was practically below the 20 value for nearly 27 sessions with the price steadily falling over 7.5% in the process.

Example of GLD chart with RSI oversold for a long period

Example of GLD chart with RSI oversold for a long period

It would have been a futile attempt in this case to attempt and catch a bottom in price, which looks a lot clearer in hindsight.

7 - The oversold bounce

The oversold bounce is a commonly occurring phase in the security. An oversold bounce is typically a counter trend rally as price corrects itself into the decline. The oversold bounce occurs during the selloff period when it is too severe. Sometimes, the oversold bounce is referred to as a dead cat bounce.

Prices intermittently bounce after a sharp selloff only to resume a new wave of selling with the bounce failing to be anything meaningful.

A dead cat bounce can occur for several reasons. The most common being that it is a result of weak long positions or buyers coming into the market. However, the failure to push the price of the security any higher often leads to the buyers capitulating and eventually the selloff resumes or at times worsens.

The sellers who buy to cover their positions are also responsible for briefly sending the prices higher, which often attracts bargain hunters as the stock’s price looks quite attractive.

An oversold bounce implies that price is correcting due to the strong nature of the descent in price. When market participants determine that the price of the security is oversold, they typically buy the stock in hopes that they are getting it cheap.

Now this may or may not be true.

For example, in each of the stock market crashes over the decade, there have been stocks that were grabbed up at a discount and some stocks that continued to fall.

The oversold bounce or the dead cat bounce occurs when many market participants deduce this information at or nearly the same time and compete to buy the stocks, briefly sending the price of the undervalued stock higher.

Example of a stock’s dead cat bounce

Example of a stock’s dead cat bounce

Following a quick and sharp selloff in price, the security attempts to stabilize as investors buy to cover or attempt to buy the bottom in price.

However, the dead cat bounce doesn’t stay for long as sellers eventually overwhelm the market with the stock resuming its declines. In each of the cases, the dead cat bounce results in lower lows being formed while the bounce itself results in lower highs.

8 - Can traders take advantage of the oversold market conditions?

The answer to this depends on a lot of factors. For one, the security in question needs to be thoroughly analyzed to determine the trends.

Oversold levels in an uptrend is ideal to buy the dips as price falls and corrects itself in the uptrend. Typically, such oversold levels are determined by analyzing the trend by means of technical indicators. It can be a bit more complex when trying to understand oversold stocks using fundamentals.

As noted earlier, it can be very subjective when it comes to figuring out whether a stock is oversold. Comparatively, using technical analysis is a lot easier to determine such levels in the market.

Traders can also use many other indicators and not just the relative strength index (RSI) to rely for the oversold signals. The stochastics is a commonly used oscillator as well and some volume based indicators can also be used to determine when the security is oversold.

To conclude, when you hear about the markets being oversold, it warrants a deeper investigation than taking the word at face value. A stock can be oversold only to correct itself and resume the uptrend, or a stock can be oversold and continue to fall steadily and eventually move into bearish territory.

There is no telling on how severe the stock’s sell off can be. While it might be tempting to attempt and catch a bottom during such selloffs it can be disastrous for the trader if they are caught in the middle of a strong sell off that offers no short term recovery in sight.

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Al Hill Administrator
Co-Founder Tradingsim
Al Hill is one of the co-founders of Tradingsim. He has over 18 years of day trading experience in both the U.S. and Nikkei markets. On a daily basis Al applies his deep skills in systems integration and design strategy to develop features to help retail traders become profitable. When Al is not working on Tradingsim, he can be found spending time with family and friends.
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