Overbought versus Oversold

In this commentary, Fear, Gold and the Dollar, Mr Holmes claimed, “Our gold-dollar oscillator (above) shows that the dollar is approaching being overbought over the past 60 trading days, while the gold is showing signs of being oversold.”

What do overbought and oversold mean in the investing world?

In the book, All About Options by Thomas McCafferty, the glossary provides the following definitions:

Overbought – A technical opinion that the market price has risen too steeply and too fast in relation to underlying technical or fundamental factors.

Oversold – A technical opinion that the market price has declined too steeply and too fast in relation to underlying technical or fundamental factors.

First, let’s look at these definitions as they seem counter-intuitive.

“Overbought” sets a mental image that supply is plentiful and prices are low. Yet, “overbought” actually means the price has risen too high.

Similarly, “oversold” seems to mean the supply has diminished and prices should be climbing higher, following the supply and demand rules. But, “oversold” means the price is too low for the situation.

Using the correct definitions – not the seemingly intuitive definitions, let’s look at the points in initial statement again. The dollar is overbought, and gold is oversold.

If the dollar is overbought, then the dollar on the currency markets trades higher than it should. Interestingly, today the dollar fell against the Euro and the British Pound. Furthermore, CNNMoney speculates the dollar will fall more due to the Europeans helping Greece with their financial woes.

Now, if gold is oversold, then the current price of gold remains too low. Again, interestingly, gold prices traded higher today than yesterday.

Somewhat conversely, this Yahoo Finance video, Gold’s Relief Rally, offers the opinion that the European difficulties will strengthen the dollar and ultimately hurt gold prices.

To demonstrate that conclusion is not always true, in another commentary, Higher Highs Coming in Gold, Peter Degraaf charts the gold and silver index ($HUI) against the dollar ($USD) from April to December 2005. Both gold and the dollar performed on an upward path rather than one up and one down.

Mr. Degraaf goes on to say, “Because of very bullish fundamentals (more and more money chasing less and less gold), and because of the length of this pullback in terms of the number of days (38), and because the bears can only control price for so long, we are much closer to a bottom (think inches), than we are to a top (think miles).”

Interesting, very interesting, times for one to play the investment game.

Make sure you do your own due-diligence research and consider not only the expertise of your resources but also their interests. Those who invest in stocks will steer you toward stocks. Those who are interested in gold will form their investment strategies around gold.