The world of stock trading is full of colorful terms and lots of jargon. That can make trading seem like it's only for a small group of experts and insiders.
That couldn't be further from the truth.
Sure, some talking heads on TV and Wall Street elites would like you to think they're smarter than everyone. But getting up to speed on what these terms are is pretty easy, and chances are you already have a pretty good idea about what they mean.
You've probably heard the term "oversold" as pundits described the market in late March and early April. All that really meant was sellers overwhelmed buyers and probably pushed stock values below where they "should" have been.
And that means the stock could bounce higher.
Think of the market as a rubber band. If you stretch it too far, it tends to snap back. Likewise, an oversold market tends to bounce back up, even if a growling bear market is in place.
You probably also heard pundits call the rally from March 23 to today a "bear market rally." What they really mean is that the market got really oversold and bottom fishers and short-term traders were taking advantage of the rubber band snapping back.
Overbought means just the opposite.
When a market or a stock is overbought, it means buyers got a little too far ahead of themselves. Look at a hot stock like Beyond Meat Inc.'s (NASDAQ: BYND) 238% surge in 2019 or Tesla Inc.'s (NASDAQ: TSLA) 114% jump since March. Both rallied at rates that were just impossible to maintain, and they fell back down to earth in a hurry.
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Some analysts will say that they moved too far, too fast. Perhaps a majority of investors piled into the stock on hope that its momentum would carry it on to even higher heights. After all, both deal in new and exotic products that were supposed to change our lives.
Unfortunately, when everyone is thinking the same way, there will soon be nobody left to buy. The stock then has nowhere to go but down to cool off.
Now that you know what traders mean when they say a stock is overbought or oversold, how can you tell?
That's simple too...
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Chart watchers have many indicators they use to determine if a stock has moved too far, too fast, whether that is higher or lower. They also have an alphabet soup of names, too, like RSI and MACD.
The good news is that most of them work pretty much the same, measuring price movement with regard to time or the stock's own trading history. It's basically like looking at velocity and acceleration. Too much of either, and trades go awry.
When you're interested in buying a stock, analyze it with whatever method you like, such as earnings growth, but before you hit that buy order, take a look at a chart with a momentum indicator. For example, if the relative strength index (RSI) is above 80 (out of 100), chances are the stock has already made a strong move and may be overbought. That means it could "snap back" a bit lower.
Similarly, a stock with an RSI below 20 is likely oversold. If you were thinking of selling it, maybe you can wait for a bounce in order to get a better price. Or, if you wanted to buy it, now would be a good time to consider it.
Using overbought and oversold indicators does not change what you buy and sell, but they can help you decide when - or if - you should buy or sell.
You can find most of these indicators on every charting software, and many are free.
And the next time you hear a pundit say the market is overbought or oversold, you will know what they mean.
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