Learn The Basics: What Do They Mean By “Oversold” In Stocks?

Novice investors are quick to ask “Why do stocks go up?” Just as quickly veteran investors still ask “Why do stocks go down?” Many stock news reports, commentaries, blogs, penny stock alerts, etc. phrase key terms which are sometimes misunderstood, especially “oversold.” This is one of the most misleading terms used from the multiple applications used to deduce a stock’s advances and declines during a trading day that actually allow for superb technical indicators.

Two terms that are frequently mentioned are that a stock being “overbought” or “oversold.”

Oversold is the more used of the two when reading an alert of a penny stock breakout about to happen which is what we will focus on here. Applying oversold and overbought as a technical stock indicator supposedly gives indications as to what stage the stock is at and whether an investor should buy or sell.

The terms oversold and overbought are being used very loosely in alerts of penny stocks and among their investors. In fact, very few are able to even define them clearly let alone spell them correctly. So what exactly does oversold and overbought mean and how can they help penny stock trading in an objective way?

The term “overbought” basically means that a stock has risen too high, too fast and/or has become overvalued or too expensive. But at which point exactly can an investor objectively say that a stock has risen too far too fast and exactly how would an investor make the  determination that a stock has become overvalued?

The terms tell us nothing in particular about the true nature of what is happening in the stock since they are used so loosely and only add to the confusion.

On a technical level, oversold and overbought are defined as the points at which prices in the stock have moved too far and/or too quickly in either direction. Usually, the concept of “too far and/or too fast” is applied to one or several moving averages, the difference between the number of advancing and declining days over a given period.

If a stock is considered overbought, technical analysts will sell, and if it is thought to be oversold, they will buy.

While this may be useful in some cases, it does not explain why we should be buying a stock that is oversold or selling a stock that is overbought.

Promoters may add something to the extent of, “The stock is considered oversold when a particular indicator has reached a certain level”. In the opinion of AimHighProfits, this does not explain nor define “oversold”; rather, it simply describes where the “certain level” for a particular indicator is. The issue becomes even more complex when one considers that there are over hundred different technical indicators in use today which can all determine different “certain levels.”.

So what then is “oversold?”

The obvious is the obvious. In order for a stock, or any asset really, to trade, there must always be a seller and a buyer, each of which believe they are getting a good deal (most of the time). You simply cannot sell shares to thin air. Another trader, market marker or specialist, broker, bank, mutual fund, etc. has to purchase the stock being offered for sale.

Common sense therefore indicates that one cannot say that when a stock is “oversold” that “too many shares” were sold.

Following a phase where a stock has seen prices drop substantially in a short time (i.e., prices moving down too far/ too fast), the stock tends to become “oversold””. This stage of the stock normally coincides with a volume surge which is evident that a large number of low-priced shares are being transferred (i.e., distributed) from one group of market participants to another.

Following the surge, which uses up a lot of selling power, the number of those sellers that are still willing to “keep giving away” shares at low (“bargain”) prices becomes exhausted. Sellers are no longer willing to dump their shares at the bid price the stock has reached where the trend becomes vulnerable and begins its reversal up.

This is when buyers move in who are bottom fishing and shorts start to cover.

In short, after a stock has had a long run in one direction, the appearance of a big volume surge means that a large number of shares are being transferred from one group of market participants to another; it is at this point that the market can become “overbought” or “oversold”.

By analyzing how big this volume surge is, how far away is it from a previous reversal point, how prolonged in time it is, you can anticipate when the stock is likely to reverse in the short-, mid-, or long-term.

The advances and declines volume can help see when to make that determination since it shows exactly where the major trading activity is concentrated.

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