Oversold Bounce

What Is an Oversold Bounce?

An oversold bounce is a rally in the prices of securities that happens due to the selloff preceding it being perceived as too severe. It could be short-lived in nature, as underlying fundamentals might in any case point to lower prices; however, the speed of the sell-off may have been too severe initially, prompting the bounce.

The opposite price action from an oversold bounce would be a selloff resulting from prices being overbought.

Understanding an Oversold Bounce

Before an oversold bounce, due to behavioral tendencies, for example, herd behavior, aversion to loss, and the temptation to panic, prices can decline more than they should based on technical and additionally fundamental analysis. Such price action can happen in quite a few markets including stocks, bonds, and commodities.

An oversold bounce implies that prices are correcting themselves upward because they went too low just prior to the bounce. Being oversold means that the price of an asset or market has fallen to a level below its fair value. Negative macroeconomic data, for example, employment figures or gross domestic product (GDP) missing their estimates can cause broad selloffs while company-specific data, for example, poor corporate earnings or downward guidance can do likewise to an individual stock.

An oversold bounce happens when investors begin purchasing more and more of a security they perceive is priced too low, causing a rapid increase in the price of that security.

Step by step instructions to Spot Oversold Conditions

The determination with respect to whether prices have fallen to a level that is oversold can be based on fundamental analysis or technical analysis. On the fundamental side, assuming that prices have been sold down lower than the book value or intrinsic value, there might be a strong case that it was oversold, or on the other hand in the event that the low price implies a price-to-earnings (P/E) ratio that is suddenly much lower than its peers. Often, an oversold condition will be motivated by fear.

With technical analysis, being oversold can be judged by checking technical indicators out. Prices that fall below a moving average, for example, could indicate the price is too low. Oftentimes, indicators, for example, oscillators are employed to determine a potential lower bound that, whenever reached, would point to being oversold. The relative strength index (RSI), stochastic oscillator, moving average convergence divergence measure (MACD), and money flow index are undeniably used by market technicians to spot oversold conditions.

When enough market participants deduce that the price of an asset is oversold, they are likely to enter that market as buyers to bid up that price to essentially the equilibrium level it ought to be at based on technical measures or valuation models. Because many people might come to this resolution at the same time and compete with each other to buy undervalued shares, prices tend to bounce up quite rapidly.

On the off chance that there are numerous short sellers in an oversold market, the ensuing bounce might be even more pronounced as those shorts are forced to cover in a short squeeze. Being oversold is a subjective measure even however it has objective considerations. Thusly, only one out of every odd "oversold" asset will experience such a bounce.

Example of an Oversold Bounce

Company ABC's stock trades at a price of $100. In their latest quarterly earnings report, the company announced earnings per share (EPS) at $1.45. Analysts had estimated that the EPS would be $1.51. This combined with the recent news that Company ABC should pay a court settlement of $2 million causes investors to be bearish on the stock. As a result, investors begin selling. As other investors notice the price of the stock falling as well as the news, they begin to sell too. Over one month, the price of Company ABC's stock goes from $100 to $85.

After this month, investors realize that the stock has fallen rapidly, particularly when compared to its book value, believing it is underpriced, or oversold. This combined with the way that the company has cash reserves of $20 million, making the $2 million court settlement not a large issue, results in investors buying the stock once more, as the long-term prospect of the company remains. Investors start rapidly buying the stock once more, the price increases, other investors jump on the bandwagon, and the stock experiences an oversold bounce.

Features

• During an oversold bounce, the price of a security rapidly goes up to a level in line with its valuation.
• The price of an asset can fall definitely due to herd behavior, aversion to loss, panic, as well as because of negative news related to the security or market.
• An oversold security is one whose price is below its book value or intrinsic value.
• An oversold bounce refers to a rally in the price of a security after a selloff that is perceived as too severe.
• Technical analysis and fundamental analysis can be used to determine whether or not a security is oversold.