Oversold stocks sometimes can provide a trigger to make a contrarian move, especially when the market is experiencing a downturn. However, it is worthwhile to consider all perspectives before you decide to buy stocks. In this article, we explain what oversold stocks are and how you can identify them.
Oversold Stocks Explained
An oversold stock is a stock that an investor believes has been heavily sold at too-low prices. Excessive sales could result from negative reports like slowing sales, weak forecasts or unfavorable government policy.
When a stock is oversold in the market, traders may believe that the market is overreacting to news about the stock. The situation could present an opportunity to take a contrarian stance on the stock.
Oversold vs. Overbought Stocks
Overbought stocks are stocks that have been bought heavily, sending their prices higher. Oversold stocks are stocks that are trading below the value that an investor believes is fair market value.
For example, let's say an executive of company XYZ is accused of a crime unrelated to the company. The scandal may cause investors to sell off the stock even though no fundamental reason to do so exists. Investors are reacting to bad news and not to the prospects of the company.
On the other hand, a company ABC may appear on a popular internet forum and members may decide to buy the shares. If institutions also get involved, additional buying could move the stock without fundamental news or logic.
One crucial factor to keep in mind is that these conditions (overbought or oversold) are often driven by market overreactions and emotions such as greed, fear or fear of missing out (FOMO).
Fundamentally Oversold
A stock can be said to be fundamentally oversold if it is trading below what investors feel is its fair value. Here, investors use fundamental metrics like price-to-book ratio, dividend yield or PE ratio to determine its fair value.
Other times, lower stock prices may result from unfavorable economic conditions such as slowing sales, weak forecasts or lower product quality, causing investors to sell the stock.
For example, in October 2022, shares of Snap fell by over 25% in a single day when the social media company reported weak revenues and issued no guidance for Q4 2022.
Technically Oversold
A technically oversold stock is one that is trading below a price level identified on the technical indicator as being oversold. The trader uses technical analysis to determine if the stock is oversold. Let's look at technical indicators that can be used to identify oversold stocks below.
1. Relative Strength Index
The relative strength index (RSI) measures the price movements of a stock on a scale of 0 to 100. If a stock is trading at 70 and above, it is regarded as overbought. If a stock is trading at 30 and below, it is regarded as being oversold.
2. Stochastics
Stochastic oscillators measure stock prices on a scale of 0 to 100. When a stock trades above 80 on the oscillator, it indicates that the stock is overbought. When the stock trades below 20, the indicator suggests that it is oversold.
3. Bollinger Bands
Overbought or oversold conditions can be established with Bollinger Bands based on the proximity of the stock price level to any of the bands. If the stock's price moves toward the upper band, this is an indication it is overbought. Likewise, if the stock price moves toward the lower band, this is an indication that it is oversold.
4. Fibonacci Retracement
The Dow Theory of Retracement determines oversold or overbought conditions using Fibonacci retracement. The theory states that the price of an asset usually retraces 50% after an initial price movement takes place.
The 50% retracement point falls between 38.2% and 61.8% of the initial price movement. If the stock falls below 38.2% of its initial price, it is oversold. For example, if Stock XYZ is trading at $10 and it falls below $6.18 (38.2%), then it is considered to be oversold.
5. Moving Average Convergence/Divergence (MACD)
The Moving Average Convergence/Divergence (MACD) shows the relationship between both the 26-day and 12-day exponential moving averages using histograms. Sometimes this relationship is shown using a MACD signal line and a zero line.
When the MACD signal line falls below the zero line, this indicates that the stock is oversold. When the MACD rises above the signal line, this indicates that the stock is overbought. However, overbought and oversold conditions with MACD are best interpreted using histograms and other technical indicators.
Considerations When Trading
Several factors should be considered when trading oversold stocks.
Fundamentals
One of the key factors to consider is if the stock's fundamentals reflect its current market position. You may need to verify if the stock price is fundamentally oversold or the market is just overreacting. If the latter is the case, the potential exists for a price reversal.
Technicals
Technical levels also play a part in stock price movements. The stock may have reached a key resistance level or broken through a support level, which resulted in overselling.
Beaten-Down Stocks Can Get Back Up
Oversold stocks don’t have to be stocks that have been left for the grave – the market could be overreacting. Price action cannot be predicted because an oversold stock can continue to plummet. Your interpretation of an oversold stock may be based entirely on your analysis or biases. Using a mix of fundamental and technical analysis will help you see the full picture before trading an oversold stock. Considering both sides puts you in a better position to make a more informed decision.
Frequently Asked Questions
Are oversold stocks good investment?
That will depend on your goals, risk tolerance and time frame for investing. Each stock has unique considerations to take into account before you make a move
Is it better for a stock to be overbought or oversold?
Both situations can offer opportunities and risks for investors. However, it is best you consider fundamental and technical analysis before making a decision on an overbought or oversold stock.
Does oversold mean undervalued?
A stock may be oversold, but it does not necessarily mean it is undervalued.