What Does It Mean When the Market Is Oversold?

When some investors use the word "oversold," they mean they have surveyed the sentiment of other investors. You will hear them say things like, "Traders I know are all saying the market is oversold," or "Wall Street veterans suggest the market is oversold." Keep in mind that these statements are usually the product of others' opinions. The majority opinion has been wrong more than once about the stock market.

Some investors use technical indicators on charts to tell them when the market is oversold. One of the most common is the Relative Strength Index. Others use something called a Stochastic Oscillator. These measures include a "mean" or average line that shows how the market rises above and below the line. When it's below that line, the thinking goes, it will have a tendency to "revert to the mean." In other words, investors expect the market to rise back up and continue its average tendency. Technical charts can be enticing, because they sound more like science than opinion. In reality, some markets during some periods do not revert to the mean.

The whole idea of identifying an oversold market is to get in on the bounce that may follow. This is a strategy for short-term traders, not long-term investors. The resulting bounce can be as little as 2 percent or 3 percent, followed by a long period of sideways moves, resulting in no further gains. There are times when the bounce is much more significant and the market soars. That's when you will start hearing analysts say that the market is "overbought." This means they expect it to drop back down to the average. In a perfect world, you could buy at the lowest point of the oversold condition and sell at the highest point of the overbought condition. However, it's very difficult to pick bottoms and tops.

Bear markets are those that go down for extended periods. Many investors think the market is oversold during the early stages of a bear market, only to find that the downtrend continues for many weeks or months, taking the market far below the point where they called it oversold. In other words, sometimes a downward move is an indication of further losses to come, and not a guarantee of a coming spike. You have to weigh the condition of the overall economy, the prospects for company growth and influences such as inflation and interest rates to determine where you think the market may go.