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why at a certain level a stock is considered overbought / oversold ?

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  • Anonymous
    1 decade ago
    Favorite Answer

    At one level of abstraction, a stock is just an income stream.

    You might have to pay $3 to buy a $1/year income stream, or $10 or $30 or $100.

    But the thing is, you know what the income stream was *last* year. You don't usually know what the income stream will be *next* year.

    If you think the prospects for a company are better than most investors do, you'll consider it oversold. If you think a company is cruisin' for a bruisin', you'll think the stock is overbought.

    And the smart thing to do is to buy oversold stocks, and short overbought stocks.

    When Kmart got into financial trouble, the prospects of future income were pretty bleak, and people sold off the stock. When they went into bankruptcy, the stock dropped off even more. In retrospect, it's obvious that the stock was oversold, but it wasn't so obvious at the time. Edward Lampert bought a bunch of it. When Kmart emerged from bankruptcy, Lampert was in the driver's seat, and he has since greatly improved the company's profitability. As a result, the stock has really shot up in price.

    A lot of people are saying Google is overbought. The company can't possibly keep growing forever at its current rate. The whiz kids that were around in Google's early days have more money than they could possibly ever spend, so many of them are using it to start new tech businesses. With Google's brain trust hollowing out like that, Google is due to stumble and fall.

    If you agree with that analysis, you would think Google is overbought. You'd sell any Google you own, and possibly consider shorting it. Maybe you'd be right. Maybe you'd be wrong. It's not a horse race *I* would want to bet on, either way.

    But the whole idea of the stock market is that there's an auction with people who think a stock is overbought selling to people who think the stock is oversold. It's pretty obvious one side is right - but *which* side? Hard to tell, sometimes.

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  • ZORCH
    Lv 6
    1 decade ago

    The concept is that there are people who will buy a stock at a certain price (buyers) and their opposite (sellers). When the stock approaches some price, the number of buyers willing to pay that price decreases. It is hard for the stock to move higher because everyone that thought it was a good buy at that price has already bought it. So, it is overbought. And, all the folks that bought it now may be interested in selling it. So, there are more sellers in the marketplace then buyers at that price and the mostly likely direction is down. Same happens on the other side of the coin, when the stock is oversold. Some stocks will bounce back and forth between trend lines for months at a time. The RSI indicator is considered pretty good, indicating overbought at 70 or higher and oversold at 30 or lower.

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  • Anonymous
    1 decade ago

    I think these terms are a little misleading. The theories are that a stock price will trend towards its moving average over time. So if a stock rises above its moving average it will tend to come back toward the moving average and in fact fall below the moving average. It is said to oscillate. It really gets considerably more complicated than that but that is more or less it in a nut shell.

    One technique uses moving average divergence to measure overbought/ oversold condition. Two moving averages are used, a slow moving average and a fast moving average. When the amount of divergence become very great, the stock is said to be be overbought or oversold. The main problem is that a stock can be overbought or oversold for months at a time. Buy or sell signals are given when a stock crosses from the negative to the positive or the opposite and when the fast moving average crosses the slow moving average.

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  • Anonymous
    1 decade ago

    right now, a lot of stocks are over sold, while two month ago those same stocks were over bought.

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