What Is an Oversold Stock?

Whether you are a professional trader or a novice who dabbles in the market from time to time, you have probably come across an oversold stock. A stock may become oversold for numerous reasons. The security's company may be maligned in the media, or the company may experience financial difficulty. And another reason that's not company-specific is simply when the overall market begins to sag. When a stock's price drops and it begins to lose value, it is considered "oversold" when its price point drops below its true value.

Understanding the Valuation Process

All stock is valued by the supply and demand of the marketplace. If a stock is being overlooked by investors, it will likely have a lower value than it should. If it is in very high demand, it may have a higher value than it should. It is up to the investor to determine what the stock is actually worth and to act accordingly on that assumption.

For example, say a tech stock is selling for $10 per share and an airline stock is selling for $20. You believe both are worth around $15. You might then sell the airline stock and buy the tech company stock so your money is on the right side of both when the market settles.

Defining an Oversold Stock

An oversold stock is one that falls victim to an overreaction by traders. When a stock's value drops suddenly due to bad reports, company problems or a mass exodus of investors who believe it may be overpriced, the stock loses value quickly. The glut of shares for sale on the open market increases supply, while demand falls precipitously. If the stock continues to fall past what the investor feels is its true value, it is considered to be oversold. Oversold stock is that which has reached a low price point that is no longer equal to its actual value.

Exploring RSI Data

The relative strength index of a stock is 100 minus 100 divided by 1 + the average value gained when the stock closed up over the past X amount of days, times the average value lost when the stock closed down over that same period. For example, say over the past 6 months a stock has closings that are up an average of 50 cents and down an average of 75 cents. The results should look like this: 100-100/(1+0.50 x 0.75)=RSI. When calculated, the RSI is around 33, and the company is likely considered oversold. You use the RSI to determine the real potential of the stock, and anything between 30 and 40 may indicate a stock is being oversold.

Evaluating Major Brands

Oversold stocks are not always those you haven't heard of. Sometimes, the biggest companies in the world are sold off in large chunks by mega-investors, leaving the stock price down and the door open for investors to jump in. Since major brands often have well-established value and extensive assets, their undervaluation tends to be short-lived.