Oversold

The term “oversold” is used to describe a market that has declined or pulled back to a point at which, historically, it has tended to reverse and move higher. Oversold is the opposite of overbought.

To identify oversold conditions in markets, traders and investors use technical indicators known as oscillators. One of the more popular oscillators for identifying overbought conditions is the Relative Strength Index.

Trading strategies that are designed to buy markets that are oversold are often called “pullback” or “mean reversion” strategies. These strategies look to buy markets that are in longer-term uptrends, but have moved lower in the short term. As a short term trading strategy, pullback or mean reversion strategies that buy markets that are oversold tend to sell those markets after they have rallied into strength.

Below is an example of a pullback or mean reversion trade in oversold market. This example comes from Larry Connors Daily Battle Plan (click here to learn more about the Daily Battle Plan), and shows both the entry and exit levels in an ETF market that had become oversold in the short term.

<img src=”http://images.tradingmarkets.com/2011/Penn/DP0314-900-oversold.gif” alt=”oversold chart”

Above, the SPDR S&P 500 Trust ETF or SPY rallying from short term oversold conditions. The technical indicator in the lower pane is the Relative Strength Index. The area highlighted in yellow indicates the time the SPY spent in oversold territory.

Generally speaking, the more oversold a market becomes, particularly an equities market, the more powerful that market’s subsequent oversold bounce tends to be. In other words, over the short term, markets that become very oversold are likely to outperform markets that are only moderately oversold, or even markets that are not oversold at all and are, in fact, even overbought.

This insight is at the heart of the research by Larry Connors and Connors Research. This research showed, for example, that from 1995 to 2007, the S&P 500 gained more than 4x its weekly average gain in just five days after moving lower for three days in a row. By contrast, over the same time period, the S&P 500 has lost money after five days following instances when it has rallied for three days in a row – rather than retreated.

While other markets, such as commodities markets, often have a tendency to “become oversold and stay oversold”, equities and equities based markets have shown a historical tendency, over the short term, to move from oversold to overbought and back again. This tendency has held up in overall up markets, overall down markets, and markets that move sideways for extended periods of time. Taking advantage of this tendency in equities and equities based markets is one of the hallmarks of swing trading.

Read more about identifying oversold conditions in How Markets Really Work: Quantitative Guide to Stock Market Behavior (Bloomberg Financial) by Larry Connors, founder and chairman of TradingMarkets and The Connors Group.


Disclaimer: The Connors Group, Inc. ("Company") is not an investment advisory service, nor a registered investment advisor or broker-dealer and does not purport to tell or suggest which securities or currencies customers should buy or sell for themselves. The analysts and employees or affiliates of Company may hold positions in the stocks, currencies or industries discussed here. You understand and acknowledge that there is a very high degree of risk involved in trading securities and/or currencies. The Company, the authors, the publisher, and all affiliates of Company assume no responsibility or liability for your trading and investment results. Factual statements on the Company's website, or in its publications, are made as of the date stated and are subject to change without notice.
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results of any individual trader or trading system published by Company are not indicative of future returns by that trader or system, and are not indicative of future returns which be realized by you. In addition, the indicators, strategies, columns, articles and all other features of Company's products (collectively, the "Information") are provided for informational and educational purposes only and should not be construed as investment advice. Examples presented on Company's website are for educational purposes only. Such set-ups are not solicitations of any order to buy or sell. Accordingly, you should not rely solely on the Information in making any investment. Rather, you should use the Information only as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments. You should always check with your licensed financial advisor and tax advisor to determine the suitability of any investment.
HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING AND MAY NOT BE IMPACTED BY BROKERAGE AND OTHER SLIPPAGE FEES. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.

All analyst commentary provided on TradingMarkets.com is provided for educational purposes only. The analysts and employees or affiliates of TradingMarkets.com may hold positions in the stocks or industries discussed here. This information is NOT a recommendation or solicitation to buy or sell any securities. Your use of this and all information contained on TradingMarkets.com is governed by the Terms and Conditions of Use. Please click the link to view those terms. Follow this link to read our Editorial Policy.