What Is the Meaning of "Oversold" in Stocks?

by Cam Merritt, studioD

Investors are always on the lookout for "oversold" stocks. These are stocks whose price has been driven so low so quickly by selling activity that they're now a bargain -- profit just waiting to be taken. The problem is that there's no light that goes on, no alarm that sounds, when a stock gets oversold. It's up to investors to decide when that's happened.

Supply and Demand

Stock prices move according to the laws of supply and demand. When the available supply of something is greater than the demand for it, the price goes down. When there's more demand than supply, the price goes up. In the stock market, the supply of a stock is determined by how many shares investors are trying to sell at any given moment. The demand is how many shares other investors are seeking to buy at that moment.

Oversold Stocks

If supply and demand for a stock are more or less equal, the price doesn't change much. But when there's a big mismatch, that's when prices really get moving. A stock becomes "oversold" when the supply surpasses demand enough that the price quickly gets pushed below the true value of a share of the stock. If a stock is selling for $11 a share and you think it's really worth $10, clearly you won't buy it. But if enough shareholders sell the stock that the price dives to $9, the stock becomes a bargain -- it's been oversold. This can happen because of panic sales -- when investors overreact.

Intrinsic Value

Whether a stock has been oversold all depends on what you think the "true" value of the stock is. And that's the trick: There is no agreed-upon true value. If there were, the world wouldn't need stock markets as they exist today. The personal finance section of a bookstore is full of theories, methods and formulas for determining what investors refer to as the "intrinsic value" of a stock. The intrinsic value is what it's really worth, as a share of ownership in a company, taking into account current conditions, growth prospects for the future and the dividends likely to be paid, the potential for price appreciation and countless other factors. "Oversold," like beauty, is in the eye of the beholder.

Overbought Stocks

The opposite of an oversold stock is, sensibly enough, an "overbought" stock. That's one whose price has been driven up sharply by demand among buyers and that outstrips the available supply, to the point that the share price now exceeds intrinsic value. And again, intrinsic value is a judgment call on the part of the investor. Stock "bubbles" occur when shares get wildly overbought: So much money is chasing so few shares that the price rises to unsustainable levels.

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About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.

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