However, fundamental indicators, only get investors so far. Technical analysts will look at technical indicators that will help them confirm an oversold condition. One of the most common of these is the Relative Strength Indicator (RSI).
The RSI is a technical indicator that measures volatility. RSI is expressed as a ratio of the average upward movement to the average downward movement of a stock over a specific period of time, typically 14 days. The RSI attempts to reveal how committed buyers and sellers are to their positions.
Like any index, the Relative Strength Index is only as good as its benchmarks. In this case, investors typically pay attention to the numbers 30 and 70. An RSI below 30 is seen as an oversold indicator. When a stock is in a downtrend, sellers will outnumber buyers meaning the index will show more lows than highs.
Traders use charting software to overlay the RSI, along with other technical indicators, on a daily chart. Here are some additional technical indicators that traders use with the RSI to identify oversold stocks:
Candlestick Patterns – Displaying a daily chart using a candlestick pattern tells traders a story of price movement by both the shape and shading of the candle. Because they are useful in identifying potential changes in market direction, accurate interpretation of a candlestick pattern can provide confirmation for an RSI level.
Bollinger Bands – these are bands that are plotted one standard deviation above and one standard deviation below a security’s exponential moving average. A security that is selling near the low end of the lower Bollinger band and has a low RSI is usually considered oversold.
Fibonacci Retracement Levels – A Fibonacci retracement level is identified by taking an extreme high and low on a stock chart and dividing the distance between the two (visually this will be the vertical distance) by the key Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, and 100%). These levels will then be defined on a chart by horizontal lines that indicate potential areas of support and resistance. It is unclear why the Fibonacci ratios are such a consistent predictor of stock price movement only that they are.
Moving Average Convergence/Divergence Oscillator (MACD) – The moving average convergence/ divergence oscillator shows the relationship between two exponential moving averages (EMAs). The most common moving averages used are the 26-day moving average as the longer average and the 12-day moving average as the shorter average. By subtracting the longer average from the shorter average, the MACD displays both the trend of the price action for the underlying security as well as the momentum of buying and selling activity. The companion to the MACD line is a signal line which is the 9-day EMA for the asset being used. The MACD is a momentum oscillator that moves above or below a center line (also called a zero line). Traders will look for signal line crossovers, center line crossovers, and divergences between the MACD line as triggers for buying (bullish divergence) and selling (bearish divergence).
What Are the Limitations to Using Technical Indicators to Find Oversold Stocks?
- A turnaround may not be immediate – Stocks don’t move in the same direction all the time, but when a stock becomes oversold, it can stay that way for a long time. That may not be an obstacle for a long-term investor, but traders will want to use other indicators to confirm a reversal is imminent.
- Investor sentiment is an imperfect metric – To put it simply, investors aren’t always rational. That means that a fundamentally sound company may see its stock continue to fall in price due to the “madness of crowds” effect.
- The definition of an oversold stock is subjective – Technical indicators offer one data point, but analysts may disagree on what it’s actually saying about the fortunes of a stock.
- Sometimes a stock is oversold for a reason – Technical indicators can show you the what, but not the why. It’s important for investors to perform their own due diligence to ensure they are not trying to catch a falling knife.