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.
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)