Buying Oversold Stock Isn't Always a Good Idea — Here's Why

Oversold is a condition where an asset trades at a lower price and there's a potential for the price to bounce. Should you buy oversold stock?

An oversold stock might seem like a great opportunity to buy on a dip. However, there are a few other factors that you need to consider along with the technical oversold signals.

There are many technical indicators that signal whether or not a stock is oversold or overbought. It's important to identify whether a stock is overbought or oversold to establish buy and sell points for them. Investors also use fundamental analysis to determine if a stock is oversold. If a stock is trading below its intrinsic value, analysts and investors might assign it to an oversold category.

The first technical indicator is the RSI (Relative Strength Index). The RSI measures the change in stock momentum. It's a range-bound oscillator, which fluctuates between 0 and 100. It's calculated based on prior periods’ average gains versus losses. As the measure approaches 100, it suggests that the average gains increasingly exceed the average losses over the period. An RSI level of 70 or more is considered overbought while a level of 30 or lower is considered oversold.

The second technical indicator is Stochastics. It compares the current price level to its range over a given period of time. It's also presented as a range between 0 to 100 but readings under 20 are considered oversold, while readings over 80 are considered overbought.

These are two opposite situations. "Overbought" describes a period of time where there has been a significant and consistent upward move in price without much pullback. In contrast, the term "oversold" describes a period of time where there has been a significant and consistent downward move in price without much pullback.

While an oversold stock might seem like a perfect opportunity to pounce and buy it, it isn't an automatic buy signal. There isn't a number that can confirm when a stock is oversold. There are situations where you should go for an oversold stock, but along with technical indicators you need to pay attention to fundamental indicators as well.

A widespread sell-off in a stock might be due to several factors such as:

• There was a more negative investor reaction to a company news than was warranted. A small down revision to a company’s earnings forecast might be met with a strong negative investor reaction. This might not have changed the company’s fundamentals in any significant way, which makes the oversold position an opportunity to buy.
• A company might have negative press due to a small factor that isn't expected to alter its business fundamentals. However, the negative press could lead to a sell-off.
• Overall negative sentiment in the market might drag down all the stocks with it, even the ones that have strong fundamentals and the ability to ride out the storm. It might be a good time to pick long-term winners in a sector sell-off.