WHAT DOES OVERBOUGHT AND OVERSOLD STOCKS MEAN?
You hear the terms “overbought” and “oversold” bandied about mostly when stock analysts are trying to make a case for you to either buy stock or sell a stock. Simply put, overbought means what it sounds like: people have been too enthusiastic about a stock and pushed it to too high a level. Conversely, oversold means people have become too pessimistic about a stock and sold it to a level where it is now under priced.
The one thing that I want you to get out of this article is that these two terms are total judgement calls by the person making them. There is no technical analysis that can really say that a stock is overbought or oversold. I may think a stock is oversold and you might disagree because you might think things are better with the company than I do. Its my opinion vs. your opinion.
See the chart below of the last three years of Netflix (NFLX). This is the best example of a stock that shows possibly being both overbought and then going down so far so fast that it becomes oversold (my judgement).
Netflix was in the news a lot in 2011 as the stock went from about $50 in 2010 to just over $300 in about a year and a half. It was a hot stock that was shorted furiously by many investors as they believed it was not worth anything near its valuation. Yet it kept going up and eventually they were proven correct that it was overbought.
The steep sell off in 2011 brought it from it’s highs all the way back down to about $60 a share in a matter of months, prompting some analysts to say that they then thought the stock was oversold. Yes, they said, the sell off was warranted but not to the degree that happened. Since then, from it’s lows the stock has now climbed back to about $100.
The terms overbought and oversold help to illustrate how the stock market is at least partially influenced by people’s emotions. When Netflix was going down, people panicked and couldn’t sell fast enough. They just wanted out no matter what. I’m sure many people sold with this frame of mind until it got to the point in the $60 dollar range where enough people started to realize that maybe the stock had gone too low and was oversold. Emotion and panic often are responsible for stocks that go up and down too fast.
It is great if you can find stocks that you think are overbought (if you like to short) or oversold if you want something that has a good chance of going up. Oversold stocks can be good short term money makers because they are at a level where most of the risk has been taken out. However, as I mentioned up top, making the “oversold” or “overbought” analysis is a judgement call on your part or someone else’s.
