What is the meaning of “oversold?” Part 1: Technical analysis perspective

September 14th, 2008

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In our previous article, Are some Aussie resource stocks oversold?, we said that

Thus, if you look at some of the massive falls in some of the smaller resource stocks, it looks that they are being oversold.

Thanks to the comment of one of our reader, Pete, we realise that there are a lot of subtleties and meaning packed in this simple word “oversold.” As such, depending on your perspective of this word, misunderstandings can arise. Therefore, we will give this word a fuller treatment.

For today, we will approach this word from the perspective of technical analysis. In technical analysis, there is a class of indicators called the “momentum indicators.” Examples of this indicator include stochastic, Relative Strength Index (RSI) and so on. Basically, these indicators measure the momentum of price movements. If the momentum is far too much on the upside, then it can be said that the prices are “overbought.” Conversely, if the momentum is far too much on the downside, then they are “oversold.”

The theory behind momentum indicators is that at the either extremes (i.e. oversold or overbought), it is a matter of time before exhaustion sets in and cause prices to reverse. In that sense, these indicators are contrarian in nature because it tells the technical analyst to sell when prices are overbought and buy when they are oversold.

So, when we apply this concept to the Australian dollar, gold, commodity and resource stock prices, many of their momentum indicators indicate that their prices are ‘oversold.’ Therefore, in the days to come, it will not be surprising to see that their prices will stage a counter-trend rally as traders who utilise technical analysis starts buying.

In the next article, we will explain the perspective of “oversold” from the value-investing perspective. It will be a long one.

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