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Overbought and "Oversold" Conditions
When a stock is following its daily volume curve normally and the
price is in order, there is a "flat" condition. But often because of
the release of news or some other market condition there is a rush
of buyers followed by a rush of sellers taking their profits. These
undulations are what technicians pinpoint as an "overbought" or
an "oversold" condition even in the short time span of a few minutes.
Here is what happens: XYZ Company announces good news before the
open. We know it will gap a bit and at the morning's open it is
already probably "overbought." So it sells off, but like most things
once it gets moving in some certain direction momentum takes over
and it moves a bit too far. Soon all the selling has placed the
stock in an "oversold" condition relative to its moving average.
Traders tend to rush back in and buy that "dip."
These conditions present themselves both at the micro level (a few
minutes) and at the macro level (a week or so). Even in a stock that
is overall in a weak condition and is falling as a trend over
several days, during those days there will indeed be times when it
is moving up and sometimes quite strongly. This is called a "dead
cat bounce" from the theory that if you drop a cat off a tall
building, it will be dead when it hits the ground but at least it
will bounce a little.
So when do most oversold conditions present themselves? Generally a
great one is on a stock that has missed its earnings. On that day,
it may have fallen many points. If you are a day trader, you watch
the morning's panic and selling to create that oversold condition
and then hop in for a small rebound. The positional player can often
catch a nice oversold condition when a stock takes a major whipping
for the day. It is usually a massive overreaction by Wall Street and
there is a good chance that it will bounce a few points the
following day. Many times taking a small position on an oversold
stock right before the close will result in a gap opening of a point
or two, but it is risky to hold overnight because more bad news can
appear.
The movement of a stock between overbought and oversold conditions
is plotted by two popular technical indicators–the moving average
convergence-divergence lines (MACD) and "stochastics." Essentially,
when the lines of these indicators cross, something should happen.
If they cross at the upper range of the scale it generally indicates
an overbought condition and it should be pulling back, and vice
versa when they cross at the bottom of the range it means that
generally they are oversold.
Watch for these extremes. Use it in conjunction with overall market
conditions and you can capture some nice moves.
http://clix.to/wallmann
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