Oversold: meaning and best indicator [Guide]
Published: 9 March 2021 by Andrew
Oversold is a term used in the world of finance when the price of a security falls below the real value of the asset and cannot always be explained by tangible reasons.
When the price of a stock continues to fall, it causes investors to lose confidence and panic selling is created, which helps to accelerate the descent to an extreme situation that can lead to a stock reaction or correction.
Let’s see what characterises oversold:
- Oversold is a subjective term that depends on what tools are used to measure it
- Oversold conditions can last a long time, so prudent traders wait for a clear reversal signal before buying
- The oversold conditions are clearly shown by technical indicators such as the relative strength index (RSI) and the stochastic oscillator
- In fundamental analysis, an oversold asset is revealed by comparing current values with previous values in terms of price / earnings (P / E)
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The word oversold is clear enough but its true meaning is not easy to understand.
This is because the real value of a stock is not easy to define and is usually based on its history.
In principle, a stock can be defined as oversold when the price is below the value that analysts expect the stock should have and can remain there for a long time.
In fact, even if the oversold condition often leads to a reaction and therefore to a rebound in prices, this does not necessarily happen.
Oversold and Overbought
Oversold and Overbought are two opposite conditions but they have similarities.
In both cases, in fact, traders expect a correction or are preparing for a reversal of the current trend.
There are two limit situations but the limit is subjective, in reality the price can continue in its rise (for overbought) as well as in its collapse (for oversold) far beyond the maximum levels of our indicator.
How to use oversold
Oversold is generally used in technical analysis to find an entry point to the upside, but this must be confirmed by another indicator or by clear signs of reversal.
Technically, a trading platform is needed and the ones shown in the introduction are perfect for analyzing oversold situations, they are safe, reliable and commission-free.
They are platforms offered by the best CFD Brokers on the market, a perfect choice to learn how to use the indicators that show the oversold conditions, also thanks to the Demo accounts they offer for free.
But understanding what to do when faced with a clear oversold signal can be tricky, which is why it would be good to see how experienced traders behave and learn from them.
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Trading with Oversold
When a trader reads a clear oversold situation on a Trading Indicator he is often led to go higher.
This is a mistake, the indication of an oversold security is not sufficient to establish a market entry, at least a confirmation indicator is needed or that the price clearly shows that it has reversed the course.
Oversold with fundamental analysis
In the Fundamental Analysis we look at the economic situation of a company and the oversold depends on the price/earnings ratio or similar valuations.
The reasons for this situation could be the result of bad news regarding the company in question, a bad outlook for the company in the future, a sector in crisis or a declining overall market.
As mentioned, the indicator used most often in fundamental analysis to determine an oversold stock is the P / E (price / earnings) ratio.
If a stock’s P / E falls below its historical range, or falls below the industry’s average P / E, investors may see the stock as oversold.
This indication can represent a purchase opportunity for long-term investments.
But as we have repeated several times, an oversold stock is not a buy signal until there is at least one other indicator to confirm it or the price has definitely reversed the trend.
Read More: Fundamental Analysis
Oversold in technical analysis
In technical analysis, oversold is much clearer, it is not necessary to make complicated financial calculations, you just need to know how to read an indicator or an oscillator.
The downside is that an indicator does not take into account fundamental data, so it often shows false signals, be careful.
The indicators most used in technical analysis to analyze oversold situations are the stochastic and the RSI, which we will discuss in more detail in the next paragraphs.
Read More: Technical Analysis
Below we have inserted a chart that clearly shows an oversold situation with an RSI underneath and a “fundamental analysis indicator” showing the Price / Earnings (P / E) ratio.
The arrows you see in the RSI indicate when the indicator has dropped below 30 points and then rose again, showing buy signals.
Not all technical signals were good times to enter the market but if we use the fundamental indicator to confirm entry, we see that the signals are far fewer and hit more frequently.
Now let’s see some strategies to use in oversold situations.
The most used indicator to evaluate oversold situations in technical analysis is the RSI.
Usually this indicator is set to 14 periods and below 30 points a stock is considered oversold.
It can be considered an upward entry when the RSI returns upward after falling below 30 points and the price shows clear signs of a reversal.
If there are too many false signals, you can decide to move the oversold threshold up to level 10 instead of level 30.
An oversold strategy can also be initiated when a negative streak is seen, i.e. at least 8 consecutive days of declines (red candles).
Obviously this number (8) can be increased or decreased depending on the market we are considering, to reduce false signals.
To enter the upward you need to link this “indicator” to the previous strategy and use it as confirmation.
Bollinger Bands are also used to determine these situations and usually act as a confirmation indicator.
When a stock’s price rises above the lower Bollinger band, we could say that we are in an oversold condition.
It can be considered an upward entry when the price, after having crossed the lower Bollinger band, returns towards the center of the channel.
Also in this case it is better to use at least another indicator such as the RSI as confirmation before entering the market.
Oversold: indicators and oscillators
There are many indicators and oscillators that show oversold situations, we have included the main ones but you can also use others and change their settings to your liking.
The Stochastic is one of the most important oscillators in technical analysis, which measures the momentum of prices.
This indicator fluctuates between 0 and 100 and oversold situations are considered to be those with the indicator below 20.
RSI (Relative Strenght Index)
Since we have already talked about the RSI (Relative Strength Index) several times, we will not dwell much on this indicator.
It is considered by many traders to be the indicator par excellence for evaluating oversold situations in technical analysis.
Usually with the RSI below 30 we are in an oversold situation.
CCI (Commodity Channel Index)
The CCI oscillator is a cyclical indicator that is commonly used to identify or confirm oversold situations on any market.
The CCI evaluates the strength of the trend and shows when a price is ready to react.
Money Flow Index
The Money Flow Index is similar to the RSI but also measures volume, so it shows results that can be very different from those of the Relative Strength Index.
Basically, the MFI measures momentum and is very accurate, especially when combined with another indicator to confirm market entry.
Oversold levels, i.e. price levels that show a certain value of an oscillator, should not be seen as a buy signal but as a warning.
An oversold stock is not a stock to buy until it clearly shows that it wants to react to this situation.
In finance, things change, so an oversold stock can stabilize in that situation, which can become the new “normal”.
To make the most of these situations, you should not be in a hurry and wait for confirmations or further signs of a reversal of the trend.
On intraday trading, an oversold situation can become a buy signal when, for example, the weekly trend is bullish and the oversold was a retracement of a longer uptrend.
But in principle you must always analyze at least two indicators before turning an oversold “warning” into a “buy”.
We can conclude this guide by saying that this condition shows a stock with a price below market expectations.
Usually it is a precarious condition but it is not a fixed rule, sometimes it can last a long time.
As you have seen there are many indicators and oscillators that show this situation but you have to find the right strategy to trade, the one that best suits your “trading style”.
To test a strategy that takes advantage of the oversold condition, it takes a lot of training and a lot of practice.
For training there is the ForexTB Trading Course, which will help you really understand what oversold means and find the right settings for each indicator. This course is free, download it now from the link below:Download the Trading Course for free by clicking here
For practice, instead, you just need to use the eToro Demo account and maybe see what the more experienced traders do with Copy Trading.
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This is a situation in which the price of a security is lower than its real value.
In addition to the RSI, there are several oscillators that show oversold situations. In our guide we show the main ones.
The strategy must include at least one confirmation indicator. For more details read our guide.
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