We all read and hear about the terms "oversold" and "overbought" a lot. "This stock is oversold. Going cheap. Time to buy." "That stock is overbought. Too expensive. Avoid or sell."
Oversold and overbought conditions are defined by oscillators. Oscillators, like the Stochastic, MFI and Williams %R, measures where the level a price is compared to the past XX days
. The TA user specifies the number of days(the default is usually 14 days).
I will use the Stochastic as example here:
The Stochastic measures where the closing price is compared to the past XX days' highest price and closing(lets take XX as 14 days). So when the Stoch is at the "oversold" region of the lower 20%, it means the closing price is very near the lowest price of past 14 days. When the Stoch is at the "overbought" region of the upper 20%, it means the closing price is very near the highest price of past 14 days.That is all that it means.
Reading into it further(like say, going "This means it is too cheap! Time to buy." or "This means it is too expensive. Avoid!") is a fallacy.
The cliche "The cheap will get cheaper, the expensive will get more expensive" demonstrates this fallacy aptly.
Let us take a look at a chart now:
As we can see, during the period the price was "oversold", the price continued to plunge 33%(cheap will get cheaper). And during the period the price was labelled "overbought", the price continued to soar by 16%(expensive will get more expensive).
There are 2 point we can learn from this:
1. We can use the Stochastic as a "momentum" indicator.
The reason why the oscillator pointed to "oversold" for such a long time was because the price kept being the lowest everyday compared to the past 14 days. (ie. the downward momentum has not reversed)
2. We can use the Stochastic as a "reversal" indicator.
The proper use the Stochastic is as confirmation of a reversal. When the Stoch rebounds from the lower 20% mark, it is a sign of a bullish reversal. Time to buy. When the Stoch rebounds from the upper 20% mark, it is a bearish reversal. Time to sell.
Of course, this is not a foolproof method to buy or sell. Notice in the chart, between the blue arrows, the Stoch rebounded from the lower 20% mark. Time to buy. But the price did not soar later. It is a failed break. Did you have your stop-loss in place?
I hope this has been helpful.
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