The Difference Between Overbought and Oversold

“Overbought” and “oversold” describe short-term stock price extremes that suggest the stock's price has gone too far in a particular direction. Overbought implies prices may have gone up too much; oversold implies prices may have gone down too much.

How Much Is “Too Much”?

Overbought means either a sharp percentage increase in prices over a few days that is larger than normal, or a growing number of consecutive days of prices moving in the same direction. For example, stocks may be overbought because they have jumped 5 percent in three days -- more than usual -- or because they have closed up for six days in a row -- also unusual. Oversold means the opposite: A steep decline or growing number of consecutive days on which prices closed down.

Implication

When a stock is overbought, the implication is that buying has pushed the price too far up and a reaction, called a price pullback, is expected. When a stock is oversold, the implication is that selling has pushed the price too far down and a reaction, called a price bounce, is expected.

Overbought and Oversold Causes

Investors often overreact to news and their buying or selling can carry prices too far in a particular direction. Buying begets buying, and selling begets selling, with these trends taking on a life of their own. Buyers may keep buying because prices are going up; sellers may keep selling because prices are going down. At some point the move is exhausted and the realization sets in that things may not be that bad or good, and a corrective move ensues in the opposite direction. For example, an interest rate cut by the Federal Reserve Board can cause several days of enthusiastic buying; a series of gloomy reports on the European debt crisis can cause several days of heavy selling. But then investors begin to realize that the Fed’s action has not solved all the problems, nor is Europe falling apart, so prices retreat from the extremes.

Secondary Indicators

Just because stocks have gone up or down too much does not mean that they still cannot go higher or lower. Overbought and oversold are often opinions that reflect someone’s view of the market, which may or may not be accurate. For example, in a bear market stocks often decline in several waves of selling, followed by temporary pauses or reversals. Oversold does not necessarily mean the end of the decline, just that a temporary bounce is likely after which the decline will resume. Nor are overbought and oversold precise measurements. For example, after five days of uninterrupted advance stocks may begin to look overbought to some market observers but can continue to advance for several more days, which would make them even more overbought or extremely overbought.

References (2)

  • Trading For a Living; Alexander Elder
  • Stock Market Logic; Norman Fosback

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.

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