It’s quite common to hear that a stock is overbought or oversold, and it’s often used as a sign that an imminent reversal is coming.
But it’s important to remember that whether a stock is overbought or oversold is secondary to that stock’s (or index’s) primary trend.
For example, most of 2024 has been very strong for the markets, and tech stocks in particular (with the exception of a brief correction in April and growing uncertainty now). But we’ve entered a short-term downtrend lately, as you can see in the chart of the QQQ below.
The last few times that’s happened this year, the short-term downtrend has reversed higher when the QQQs have encountered oversold conditions as measured by the Relative Strength Index (RSI; more on that below).
Naturally then, traders are looking for the same oversold conditions to signal a green light if the RSI gets back to the lower bound (30 on the RSI in the chart below). But should we expect it?
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As we saw in April and early August, when an index or stock is oversold in a bull market, that oversold condition marks selling fatigue in the continuing uptrend. In essence, short-term selling and profit-taking drag prices lower while investors are still eager to buy.
And while we’re again approaching both the oversold RSI level and the rising 200-day moving average, the reason that this time could be different is the QQQ’s failure to break back into the trend channel it had been in all year.
The hastily drawn green line on the chart above is roughly consistent with the lower (rising) support level since November of last year. It marks, broadly, a period of higher highs and higher lows, which defines an uptrend.
Support and resistance levels are generally not binary but tend to be measured on a spectrum and are better thought of as zones of support and resistance with varying degrees of significance.
The 50-day line in the chart above, for instance, was a support level until it was breached in April and became one again shortly thereafter; the 200-day moving average has only been tested once and held in early August.
There’s a well-known Wall Street adage, “The trend is your friend,” which should be taken to mean that the prevailing trend is a stock’s North Star … until it isn’t.
When you’re attempting to identify a primary trend, a good rule of thumb is that more established, longer-term trends trump shorter-term trends. That’s why we will periodically point readers to long-term charts (like the 100-year stock market chart) as evidence that, over the long haul, stocks will trend higher.
Secondary to that ultra-long-term chart would be secular bull or bear markets, where stocks can be trending higher or lower for years on end. After that, you’d look to multi-week moving averages like those used in our own Cabot Trend Lines, and then you’d look for multi-day averages, multi-hour, etc.
Stocks in oversold (or overbought) territory can remain there if a longer-term trend is dominant. A stock can easily show overbought conditions on an intra-day chart if it’s going through a period of multi-day or multi-week accumulation.
Even overbought conditions on the same time scale can remain in place if a stock is trending higher. In fact, we saw it with the QQQs in December, January, June and July.
When a stock is oversold or overbought it’s not a green light to buy or sell shares. Instead, technical traders are looking for signs of a possible reversal of the prevailing trend. We’ve written before about using divergence in indicators like On Balance Volume to bolster the case for a potential reversal, but remember, the trend is your friend, don’t fight it.
Which brings us back to the chart above.
The rejection off the primary trend in mid-August (green line; primary support levels tend to become resistance after a break in trend) has, for the time being, invalidated 2024’s bullish trend simply because the QQQs failed to set a new higher high.
Can it consolidate here and emerge to new highs and resume the uptrend? Certainly.
But because it no longer meets the “higher highs and higher lows” requirement, the QQQs are now in the woods (trend-wise).
That adds a degree of uncertainty that this bull market hasn’t really faced yet. We could bounce and resume the uptrend, we could consolidate for a period, or the degraded uptrend could turn into a downtrend that pushes us lower.
The important thing to remember is that, as of right now, we don’t have a prevailing bull trend to lean on as the QQQs approach their oversold levels on the RSI. If they get there, it shouldn’t be an automatic buy sign.
More on RSI
RSI, an abbreviation for Relative Strength Index, was devised by J. Welles Wilder Jr. and introduced in his 1978 book, New Concepts in Technical Trading Systems. It compares the percentage change on up and down periods over a specified timeframe (usually 14 periods). Readings above 70 are considered overbought and readings below 30 are considered oversold, with the most extreme readings (100 or 1) only coming during the strongest of trends (a stock rising every day for 14 days would trigger a 100 reading, for instance).
The RSI is one of the most-referenced momentum indicators and is very simple to read.
And, usually, if you hear that a stock is oversold or overbought, it’s probably in reference to the RSI.
What Resolves Overbought or Oversold Conditions in Stocks?
Like with almost everything chart-related, price and time are the two factors that determine whether a stock is oversold or overbought. A quick correction in price (reverses direction) can resolve overbought and oversold conditions (as we see with the two bounces earlier this year above), as stocks trading in a range will bounce between the upper and lower bounds of the range. Alternatively, a period of consolidation can also bring overbought stocks back in line, even if they’re at higher prices.
So, next time you see a call for a stock or index recovery based on oversold conditions, ask yourself the following questions:
The Oversold Stock Checklist
1. Is there a technical trend in the stock?
2. What is the longest-term trend in the stock?
3. Is that trend at risk of being invalidated if the shorter-term trend continues?
4. As the shorter-term trend meets the longer-term trend, are there signs of momentum reversals (such as the RSI)?
5. What is my course of action if the longer-term trend overrides the short-term trend, or, conversely, if the short-term trend prevails?
For now, the longer-term trends are still pointing higher, but recent volatility has raised the specter of lower prices if this short-term downtrend shows staying power.
If we see continued lower prices, it’s likely that oversold RSI conditions will coincide with support levels like August’s lows or the 200-day moving average.
If the QQQs trade through those levels, it should be seen as the marker of a new downtrend, and oversold indicators should be thrown out the window.
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