What is an overbought condition?

When a security is said to be overbought it is said to be trading above its intrinsic value. An overbought condition is said to reflect a short-term trend of price movement. The expectation, though not always the reality, for an overbought stock is that it will turn downward. Although overbought means a stock is reflecting a bullish trend it should not be taken as a predictor of the broader stock market. A security can be overbought whether the stock market is in a bull market or a bear market. By itself, the condition of a stock being overbought does not mean that investors should not own the stock. It does suggest, however, that it may be a time to take some profits and wait to buy more shares when the stock price moves lower.

The opposite of a stock being overbought is a stock that is oversold. An oversold stock is a stock that is trading at a discount to its intrinsic value. Using the same logic of an overbought stock, the fact that a stock is oversold does not mean it is an underperforming stock.

One of the common ways to notice trends for stocks that are overbought or oversold is by looking for support and resistance levels. Support levels indicate a low price level that a stock does not move below. A resistance level is a price level that a stock does not move above. When a stock trades between clear lines of support and resistance, it is said to be trading in a range. Rage trading can be a very profitable trading strategy that is based on buying and selling overbought and oversold stocks.

Any security can experience an overbought condition. For example, crude oil and gold are two assets equities other than stocks that experience frequent price movement that is based on investor sentiment. However overbought and oversold are terms frequently discussed in terms of individual stocks.

For every stock, there are only so many outstanding shares available for public trading. A stock becomes overbought when there are more buyers than sellers in a compressed time frame. When there is good news about a stock, it can cause the shares to experience rapid price movement above its intrinsic value. As we stated earlier, when analysts declare that a stock is overbought it does not mean that the stock is underperforming. It is a notion of value.

An overbought condition can be confirmed through fundamental analysis or technical analysis. Investors who practice fundamental analysis will use a stock’s price-to-earnings (P/E) ratio. Investors will look at a stock’s P/E ratio in context with other companies in its sector. If the stock has a P/E ratio that is significantly higher than others in its sector, it is usually a sign that a stock is overbought.

Traders will use technical indicators such as the Relative Strength Index (RSI) to confirm an overbought condition and then plan trades accordingly. The RSI for a stock is a measure of volatility and expresses a ratio of the average upward movement to the average downward movement over a specific period of time, typically 14 days. An RSI reading above 70 indicates an overbought or bearish indicator. An RSI below 30 is seen as an oversold, or bullish, indicator. When a security is in an uptrend, the RSI will tend to stay above 30 and should frequently rise to 70 or above. This is because when a stock is overbought buyers outnumber sellers so traders would expect a security to show more gains than losses. Conversely, when a stock is exhibiting undersold conditions, the RSI will stay below 30 and only occasionally rise to 70. When a security is in a downtrend, the index should show more lows than highs. The key takeaway is that RSI is a measure of volatility and momentum, not price movement.

 Traders use charting software to overlay the RSI, along with other technical indicators, on a daily chart. Other technical indicators that traders use in conjunction with the RSI to identify overbought/oversold conditions include:

1. Bollinger Bands– these are bands that are plotted one standard deviation above and one standard deviation below a security’s exponential moving average. A security that is selling near the high end of the upper Bollinger band and has a high RSI is usually considered overbought.
2. Fibonacci Retracement Levels– A Fibonacci retracement level is identified by taking an extreme high and low on a stock chart and dividing the distance between the two (visually this will be the vertical distance) by the key Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, and 100%). These levels will then be defined on a chart by horizontal lines that indicate potential areas of support and resistance. It is unclear why the Fibonacci ratios are such a consistent predictor of stock price movement only that they are.
3. Moving Average Convergence/Divergence Oscillator (MACD)– The moving average convergence/ divergence oscillator shows the relationship between two exponential moving averages (EMAs). The most common moving averages used are the 26-day moving average as the longer average and the 12-day moving average as the shorter average. By subtracting the longer average from the shorter average, the MACD displays both the trend of the price action for the underlying security as well as the momentum of buying and selling activity. The companion to the MACD line is a signal line which is the 9-day EMA for the asset being used. The MACD is a momentum oscillator that moves above or below a center line (also called a zero line). Traders will look for signal line crossovers, centerline crossovers, and divergences between the MACD line as triggers for buying and selling.

Like any technical indicator, overbought indicators such as the RSI are not infallible. There are times when investor sentiment will spur the price of an asset to even higher levels. That doesn’t mean there won’t be a correction eventually; it just means that even the most accurate indicators such as a well-defined resistance level may not create the price movement traders are looking for at the moment they are looking for it to happen. However, it is generally a good indication that it may be an ideal time for profit-taking even if that means an investor may miss out on short-term price movement. When traders see evidence of a stock continuing to extend gains despite evidence of being overbought, they can set trading stops at progressively higher levels to help ensure they lock in profits while ensuring they exit trades before the stock undergoes a correction.