“Overbought” and “oversold” describe short-term stock price extremes that suggest the stock's price has gone too far in a particular direction. When a stock is classified as market overbought, it means experts think that it's selling for more than it's actually worth. An oversold stock, on the other hand, is one that analysts see as trading below what it is really worth.
Overbought and oversold stocks are those that analysts see as not trading for their true worth. An overbought stock may be selling for more than it's worth, while an oversold stock may be worth more than its current trading price.
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 market 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.
Implications of Overbought Stocks
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.
Why Stocks are Overbought and Oversold
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.
Understanding Secondary Indicators
Just because stocks have gone up or down too much does not mean that they still cannot go higher or lower. Oversold and overbought stocks 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 stock and oversold stock 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 market overbought or extremely overbought.