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Two Words That Should Guide Your Trades

Real Money's Paul Price explains how stock market fluctuations led to price swings as the S&P 500 moved between being overbought and oversold—and what that means

Trading 101 introduces you to the idea of Buy Low, Sell High. For investors just getting their feet wet, “High” and “Low” are the watchwords.

Now, welcome to upperclassman trading. In these halls we tend to prefer the terms “Overbought” and “Oversold.” They’re two of the most important terms to understand in trading, as they capture not only price fluctuation but also potential for volatility and market action as well. By analyzing his investments in stocks like Caleres  (CAL) - Get Caleres, Inc. Report, Designer Brands  (DBI) - Get Designer Brands Inc. Class A Report and Jo-Ann Stores JOAN, Paul Price dives in: 

“Early October saw the S&P 500 reach its most oversold level in more than a full year. The previous most recent oversold reading came just ahead of last year's presidential election," Price wrote recently on Real Money.

"We all know now that was a spectacular time to be buying shares."

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In a nutshell, a stock has been overbought when investors have gone too far in on it. Traders keep buying up shares, pushing up the price and the trading activity until the stock reaches excessive levels of both relative to any underlying value the company actually has.

Oversold is the opposite. Where investors tend to overbuy in a rush of greed, they tend to oversell out of fear. Traders keep selling shares, driving up the trading activity but driving down the price until (again) the stock reaches levels that don’t relate to any underlying value that the company actually has.

Fundamental traders try to spot an overbought stock by looking at the company itself. How does its business model and market position look? Technical traders look for trading patterns on the stock’s chart and how its price matches up with historic trends.

Check out Price on Real Money to see how he looks at these issues in action as he analyzes his own portfolio.

Get more trading strategies and investing insights from the contributors on Real Money.