Overbought is a term used when a security is believed to be trading at a level above its intrinsic or fair value. This generally describes recent or short-term movement in the security’s price and reflects an expectation that the market will correct the price in the near future. This belief often stems from technical analysis of the security’s price history, but fundamentals can also play a role. A stock deemed to be overbought might be considered a candidate for sale.
The opposite of overbought is oversold, where a security is thought to be trading below its intrinsic value.
Key Insights
- Overbought refers to a security with a price above its intrinsic value.
- Investors commonly use price-earnings (P/E) ratios to determine if a stock is overbought, while traders rely on technical indicators, like the relative strength index (RSI).
- Fundamental analysis compares an asset’s market price to its predicted value based on financial statements or other underlying factors.
- The term ‘overbought’ is subjective. Traders and analysts use various tools, so interpretations may differ on whether an asset is overbought or has the potential for further growth.
Demystifying Overbought Conditions
Overbought signifies a security that has faced persistent upward pressure, suggesting a potential price correction according to technical analysis. The bullish trend might be fueled by positive news about the underlying company, industry, or the broader market. Continuous buying pressure can self-perpetuate, leading to sustained bullishness seemingly beyond reasonable expectations. Traders often refer to such assets as overbought and may anticipate a price reversal.
Fundamentally Overbought
Traditionally, the price-earnings ratio (P/E) has been the standard indicator of a stock’s value. Analysts and companies use either publicly reported results or earnings estimates to establish the appropriate price for a stock. If a stock’s P/E rises above that of its sector or a relevant index, it might be seen as overvalued, deterring investors from buying temporarily. This represents fundamental analysis, which leverages macroeconomic and industry factors to determine a stock’s fair price.
Technically Overbought
The rise of technical analysis has enabled traders to utilize indicators of a stock’s performance to forecast price movements. Indicators evaluate recent price, volume, and momentum data. Traders employ these technical tools to identify overvalued stocks, labeling such equities as overbought.
Pricing channels like Bollinger Bands are frequently used to spot overbought areas. On a chart, Bollinger Bands are set at multiples of a stock’s standard deviation above and below an exponential moving average. When the price touches the upper band, the stock may be considered overbought.
Identifying Overbought Stocks with RSI
Technical analysis has evolved, providing traders with advanced calculations to detect overbought stocks. The stochastic oscillator developed by George Lane in the 1950s analyzes recent price movements to predict changes in a stock’s momentum and pricing trend. This foundational tool led to the relative strength index (RSI), the primary overbought indicator.
The RSI measures the intensity behind price movements over a recent period, typically 14 days, and is calculated as follows:
1RSI = 100 - 100 / (1 + RS)
RS represents the average upward to downward movement ratio over a specified period. A high RSI, generally above 70, signals an overbought condition, suggesting a potential market correction. Traders often confirm this indication using Bollinger Bands. Typically, if a stock’s high RSI coincides with its price nearing the upper Bollinger Band, it is likely considered overbought.
Real-World Example: Overbought Conditions Using RSI
Here’s a practical example of identifying overbought conditions using a high RSI reading:
In the above chart, the oversold RSI conditions (below 30) forecasted a price rebound in October. Conversely, the overbought RSI conditions (above 70) in February could imply an imminent price consolidation or decline.
Related Terms: oversold, RSI, technical analysis, Bollinger Bands, fundamental analysis, momentum investing
