One of the tools in the tool kits of investors looking to assess whether or not a stock is oversold or overbought relative to the historical range in which the stock has traded is to take a look at a 50-day or 200-day moving average of the given company.
A moving average can provide an investor with a relatively accurate snapshot of how a stock’s current price level relates to its historical level, indicating how bullish or bearish investors are on that particular security at a given point in time.
As with most high-level metrics, moving averages have a number of significant downsides for investors who take these numbers at face value.
For starters, the specific catalysts which would have taken a stock much higher or much lower in recent trading sessions would not be available at first glance – it would be up to the investor to do independent research to determine how truly oversold or overbought a stock is relative to catalysts which may have changed the potential future cash flows of the security’s underlying business model.
Secondly, moving averages make the key assumption that a reversion to the mean will occur over some point in time. Those looking at the stock charts of companies which continue to skyrocket over time would know that calling a company such as Amazon.com, Inc. (NASDAQ:AMZN) overbought based on its moving average over nearly any time frame during the past 20 years would have pretty poor performance.
Invest wisely, my friends.
