Overbought
What is Overbought?
Overbought is a term used when a security is believed to be trading at a level above its intrinsic or fair value. Overbought generally describes recent or short-term movement in the price of the security, and reflects an expectation that the market will correct the price in the near future. This belief is often the result of technical analysis of the security's price history, yet fundamentals may likewise be employed. A stock that is overbought might be a decent candidate available to be purchased.
The opposite of overbought is oversold, where a security is believed to be trading below its intrinsic value.
Overbought Explained
Overbought refers to a security which has been subject to a persistent upward pressure and that technical analysis suggests is due for a correction. The bullish trend might be due to positive news regarding the underlying company, industry or market in general. Buying pressure can feed on itself and lead to continued bullishness beyond what numerous traders consider reasonable. When this is the case, traders refer to the asset as overbought and many will bet on a reversal in price.
Fundamentally Overbought
Generally, the standard indicator of a stock's value has been the price-earnings ratio (P/E). Analysts and companies have used either publicly reported results or earnings estimates to identify the appropriate price for a particular stock. Assuming that a stock's P/E rises above that of its sector or a relevant index, investors might see it as overvalued and pass on buying until further notice. This is a form of fundamental analysis, which uses macroeconomic and industry factors to determine a reasonable price for a stock.
Technically Overbought
The rise of technical analysis has allowed traders to zero in on indicators of a stock to forecast price. These indicators measure the recent price, volume, and momentum. Traders use technical apparatuses to identify stocks that have become overvalued in recent trading and refer to these equities as overbought.
Some traders use pricing channels like Bollinger Bands to spot overbought areas. On a chart, Bollinger Bands are positioned at a multiple of a stock's standard deviation above and below a exponential moving average. When the price reaches the upper band, it very well might be overbought.
The most effective method to Identify Overbought Stocks with RSI
Technical analysis has provided traders with increasingly sophisticated computations to identify overbought stocks. George Lane's stochastic oscillator, which he developed during the 1950s, examines recent price movements to identify imminent changes in a stock's momentum and pricing trend. This oscillator established the groundwork for the technical indicator which has become the primary indicator of an overbought stock, the relative strength index (RSI). The RSI measures the power behind price movements over a recent period, typically 14 days, utilizing the accompanying formula:
RS represents the ratio of average upward movement to descending movement over a specified period of time. A high RSI, generally above 70, signals traders that a stock might be overbought and that the market ought to correct with descending pressure in the near term. Numerous traders use pricing channels like Bollinger Bands to affirm the signal that the RSI generates. On a chart, Bollinger Bands lie one standard deviation above and below the exponential moving average of a stock's recent price. Analysts that identify a stock with a high RSI and a price that is edging toward the high end of its upper Bollinger Band will likely consider it to be overbought.
Example of Overbought Conditions Using RSI
Here's an example of a chart with a high RSI reading that suggests overbought conditions:
In the above chart, the oversold RSI conditions (below 30) predicted a rebound in the stock price in October. The overbought RSI conditions (above 70) in February could indicate that the stock will consolidate or move lower in the near-term.
Highlights
- Overbought refers to a security with a price that is higher than its intrinsic value.
- Numerous investors use price-earnings (P/E) ratios to determine on the off chance that a stock is overbought, while traders use technical indicators, like the relative strength index (RSI).
- Ultimately, overbought is a subjective term. Since traders and analysts all use different apparatuses, some might see an overbought asset while others see an asset that has further to rise.
- Fundamental analysis can likewise be used to compare an asset's market price to its predicted value based on financial statements or other underlying factors.
