1. There are several factors which can cause stocks to be oversold or overbought as they easily affect the prices within the market. Just like any other economic good, stocks have the market factors of supply and demand as their primary external determinant. As the demand and supply for a stock changes over time, as often as every hour, the price changes correspondingly.
The more prices rise, the more attractive it becomes to investors to sell their shares for a profit. At the other end, when prices start to consistently reduce, it prevents a suitable opportunity for prospective buyers to get a good bargain. Consequently, increasing prices will attract sellers while decreases will attract buyers.
Once investors begin to buy up low price stocks, it gets to a point where the increase in demand causes a rise in price back to normal. In the same way, when the sale of high-priced stocks causes the supply to skyrocket, it forces the price down back to its normal level.
A stock is considered to be overbought when it has reached prices that are much higher than normal, and likely to fall back down. It is also said to be oversold when its price has gone to an all-time low, a point from which it is likely to return back up.
Other external factors such as emotional reactions from investors will also affect stock prices and move them between their overbought and oversold points. When events occur or some news spreads that causes investors to have a panic reaction to a stock's price, they begin to make rash decisions that go against natural economics.
In such cases, you find many people selling while prices are decreasing or buying excessively with prices rising above normal. Of course, when these actions cause the stocks to become overbought and oversold, they change prices once again.
2. A stock chart tool that is popularly used to measure overbought and oversold stocks is the stochastic indicator. It is a line that shows the fluctuations in the closing prices of a stock, and investors typically use it to determine a stock's oversold or overbought conditions. This, in turn, helps them to determine the best time to either buy or sell.
When the stochastic indicators rise above 80 on the chart, it is considered to be an overbought situation while an oversold situation is shown by stochastic indicators below 20.
3. A Bollinger band is one of the most common ways to determine the price situation of a stock by directly using the chart. This band is used to determine the direction and range of prices, as well as the volatility.
It typically consists of three lines; a middle one and an upper and lower one. The middle band is the measure of the moving average while the two outer lines represent the volatility.
An overbought stock is one that is trading nearer the upper band while one that is undersold trades closer to the lower band.
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