What it means
Technical analysis studies price charts and trading patterns instead of company accounts. One of its core ideas is that prices can move too far in one direction and then snap back.
When a share has dropped steeply over a few days, bargain hunters and traders closing short positions (bets on a price fall) often push it up. Analysts use indicators to spot oversold conditions.
The most common is the relative strength index, or RSI, which scores recent price strength from 0 to 100. A reading below 30 is traditionally described as oversold, and above 70 as overbought, though these cut-offs are conventions and not laws.
A bounce can be useful to traders, who may use it as a short-term buying opportunity or a chance to sell at a better price. It is also a warning to long-term investors not to confuse a rally with a recovery.
A fall driven by weak profits or rising debt can resume after the bounce is over. Often the bounce is called a dead cat bounce when it fails and prices continue falling.
Telling the two apart is difficult in real time, because both look like a sudden rise after a drop. Volume, news and the broader market can give clues but not certainty.
Corporate finance teams care in a practical way. A bounce may offer a better moment to sell shares held as an investment or to buy back stock, but decisions should rest on the underlying value of the business.
Some traders pair the RSI with other tools, such as moving averages or levels where the price has previously stopped falling. A bounce that begins at an old support level and comes with rising volume is generally regarded as stronger than one that appears from nowhere.
In practice
Real-world examples.
Example
A technology share falls 20% in five days after a sector sell-off, taking its RSI to 24. The next morning it rises 4% as traders buy the dip. The rise stalls a few days later below the earlier price.
Example
A commodity company's shares drop sharply in line with falling metal prices. A fund manager who thinks the metal price has fallen too far buys a small position. The price bounces 7% and she sells part of it.
Example
An investor sees a bank share rise 5% after a steep decline and treats it as a full recovery. He buys heavily, but poor results are published the following week. The shares fall to a new low and he takes a loss.
Formula
Calculation
RSI = 100 - (100 / (1 + RS))
RS = average gain over the period / average loss over the period
Over a 14-day period a share has an average daily gain of $0.50 on its up days and an average daily loss of $1.50 on its down days. RS = 0.50 / 1.50 = 0.3333. RSI = 100 - (100 / 1.3333) = 100 - 75 = 25. Because 25 is below 30, the share is considered oversold.
Reading the result: a reading of 25 signals that recent selling has been heavy, and a bounce is possible. If the share then rises from $42.00 to $44.10, the bounce is (44.10 - 42.00) / 42.00 = 5%, but the signal gives no guarantee about how far or how long the rise will last.
If the average loss were $1.00 instead, RS would be 0.50 / 1.00 = 0.5 and RSI = 100 - (100 / 1.5) = 33.3, which is above 30 and so not oversold, showing how sensitive the reading is to the size of recent losses.Case study
Seen in the real world.
Ironvale Energy is an illustrative, fictional company whose shares dropped 28% in two weeks when oil prices fell. Its RSI reached 22, and short sellers began to close their positions.
The shares bounced 9% in three days, and a small investor bought, believing the recovery had begun. The company then warned that lower prices would cut its profit by a third, and the shares fell below the previous low.
A professional trader in the same illustrative story had bought on the first day and sold after the 9% rise, taking a quick gain. The lesson is that a bounce can reward quick action but punishes those who mistake it for a lasting turn.
Watch out
Common mistakes.
- Treating an oversold reading as a guaranteed buy signal, when prices can stay oversold for a long time.
- Assuming a bounce means a recovery, when it is often just a pause in a longer decline.
- Ignoring the reason for the fall, such as weak profits or rising debt, which may continue to drag the price down.
Questions
People also ask.
What is oversold?
It means the price has fallen quickly enough for indicators such as the RSI to suggest that selling is stretched, usually below a reading of 30.
How long does a bounce last?
It can be a few hours or a few weeks, and there is no reliable rule.
Is an oversold bounce the same as a dead cat bounce?
They look alike, but the dead cat bounce is the name for a bounce that fails and is followed by further falls.
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