What Does It Mean for a Stock to be Oversold? Illustrative Examples

What Does It Mean for a Stock to be Oversold? Illustrative Examples

What Is Oversold?

The phrase 'oversold' indicates a scenario where the price of an asset has decreased significantly and could potentially rebound in the future. However, it's important to note that an oversold condition may persist for a considerable time period and doesn't necessarily guarantee a price rally. Various technical indicators can identify oversold and overbought levels by assessing the current price in relation to past prices. Additionally, assessing the fundamentals of an asset can help determine whether it is potentially oversold, having diverged from its usual value metrics.

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Key TakeAway
  • The term "oversold" is open to interpretation, as traders and analysts use various techniques that can lead to different conclusions. While some may consider an asset oversold, others may believe that it still has room to decline.
  • Sustained oversold conditions can be extended, and it is prudent for traders to wait for the asset's price to stabilize and begin to show signs of upward movement before initiating a purchase.
  • Technical indicators, including but not limited to the relative strength index (RSI) and stochastic oscillator, can identify oversold conditions in an asset.
  • An asset that is potentially oversold can be identified by analyzing its fundamentals such as price-to-earnings ratio (P/E ratio) and forward P/E ratio, by comparing the current values to prior values.

What Does Oversold Tell You?

Investors who focus on fundamentals may consider an asset to be oversold when it is trading significantly below its intrinsic value, whereas technical analysts generally rely on oversold indicators such as Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD). Although the two groups use different methods, both can be effective in identifying oversold opportunities in the market.


Fundamentally Oversold

Fundamentally oversold stocks (or any asset) are those that are believed to be trading below their intrinsic value due to various reasons, such as negative news or outlook for the company, unpopularity of the industry, or a bearish overall market sentiment.

Historically, a widely used metric to assess a stock's worth is the price-to-earnings (P/E) ratio. Financial experts and investors analyze the reported financial results or earnings forecasts to determine the reasonable price range for a given stock. When a stock's P/E ratio drops to the lower end of its historical range, or falls below the sector's average P/E ratio, investors may consider the stock undervalued. Such a scenario could present an opportunity to buy and hold the stock for the long term.


An illustration of this concept can be seen in a scenario where a stock that has historically had a P/E of 10 to 15 is now trading at a P/E of five, which could prompt investors to examine the company further. If the company is still financially healthy, the stock may be considered oversold and present a good buying opportunity. However, it is important to conduct thorough analysis as there may be underlying reasons why investors have lost interest in the company.

Technically Oversold

Technical traders can utilize a range of indicators to determine oversold conditions, which solely depend on the current price in comparison to previous prices, disregarding any fundamental data.

George Lane's stochastic oscillator, which was created in the 1950s, analyzes recent price fluctuations to detect shifts in a stock's momentum and price direction. On the other hand, the Relative Strength Index (RSI) calculates the strength of price movements over a given period, usually 14 days.

An RSI reading below 30 is often considered an oversold condition, indicating that the stock's price has been declining and may be due for a reversal. However, traders should exercise caution since this does not necessarily mean the stock will immediately rally. Oversold conditions can persist for an extended period, and many traders prefer to wait for confirmation that the price is rebounding before making any trades. One possible approach is to wait for the RSI to move above 30, signaling that the stock is no longer oversold and is starting to trend higher.


Certain traders rely on price channels such as Keltner Channels to identify oversold areas. These channels are composed of a moving average with upper and lower bands situated a certain number of average true ranges (ATRs) away. When the price drops below the lower band, it may indicate an oversold condition. Traders usually wait for the price to recover and move back into the channel before considering a buy signal.

Examples of Oversold Indicators and Fundamentals


The depicted chart showcases two technical tools below the price graph. The upper tool is a relative strength index (RSI), while the lower one is a price-to-earnings ratio (P/E).

In the RSI indicator, the arrows are marked where the RSI dropped below the oversold level of 30 and then rose above it, indicating a potential buying opportunity after an oversold condition. Some of these signals resulted in price increases, while others experienced a temporary continuation of the downward trend.

The P/E range that defines an oversold level will vary from stock to stock. In the case of this particular stock, buying near a P/E of 10 has historically presented a profitable opportunity, as the price has tended to move higher from that point.


The Difference Between Oversold and Overbought

If an asset is trading at the upper portion of its recent price range or is trading at the high end of its fundamental ratios, it may indicate an overbought condition. Technical analysts may use indicators such as the Relative Strength Index (RSI) to identify overbought levels, while fundamental analysts may use ratios such as the price-to-earnings (P/E) ratio. An overbought condition does not necessarily mean the asset should be sold, but it may indicate the need for further analysis to determine whether the asset is overvalued and whether it is time to take profits or adjust the investment strategy.

Limitations of Using Oversold Readings

Some traders erroneously interpret oversold as a signal to buy. In reality, it serves as more of an indication. It informs traders that an asset is trading at a low price range, or at a lower fundamental ratio than its usual value. This does not necessarily imply that the asset should be purchased. Many stocks appear inexpensive while their price continues to decline. This can happen because most oversold indicators rely on past performance. If investors perceive a gloomy future for a stock or any other asset, it may continue to be sold off even if it appears cheap based on historical data.


Although an oversold reading can be an indication of a potentially good buying opportunity, it's important for traders to exercise caution and not immediately act on the signal. The market can remain oversold for an extended period, so traders may want to wait for confirmation that the price is indeed starting to move up before making a trade based on an oversold signal. This approach helps to avoid buying into a potential downtrend.

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