Being able to identify overbought and oversold conditions is an important aspect of investing in the stock market. There are a number of tools used in the financial markets to ascertain these conditions prior to entering and exiting trades. While technical analysts rely on trading tools to ascertain oversold conditions, fundamental traders base their investment decisions on underlying fundamentals.
What is oversold?
Oversold is a term used in the stock market to refer to a stock whose share price has dropped significantly to a level where traders believe it is undervalued significantly. While oversold conditions signal a potential price bounce back, it is important to note that such conditions can last for a long time.
There are two ways to determine if a stock is oversold:
A stock is considered fundamentally oversold if it is trading below its true value or below its average fundamentals. The conditions come into being on investors selling a stock in response to bad news or downbeat outlook that raises concerns about long-term prospects.
Price to earnings ratio is a financial metric used to ascertain if a stock is fundamentally oversold. A stock trading below its average P/E range is considered oversold. For instance, if a stock has historically had a P/E of between 6 and 10 but currently trading with a P/E of 3, the same could indicate oversold conditions.
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Technical traders rely on technical tools to ascertain if a stock is trading in oversold conditions. Technical tools stand out in this case as they try to compare the current price with prior prices. Stochastic Indicator is one such tool that can signal a stock is oversold upon comparing current share price with historical trends.
Relative Strength Index is another indicator used to ascertain oversold conditions in the stock market. Whenever the indicator drops below the 30, traders interpret the same as oversold conditions. Bollinger Bands are other effective tools for identifying oversold technical conditions. Whenever the price of a stock reaches the lower band, the same could signal oversold conditions.
Oversold Reading limitations
While oversold conditions signal a potential price bounce back, the same is not a signal to start buying immediately. A stock can remain in oversold conditions longer than anticipated, until all the technical and fundamentals align to support a bounce back.
For that reason, oversold conditions should only be interpreted as an alert as it indicates a stock is trading at the lower range of its most recent price range.