Overbought is a highly subjective term, as a stock can remain overbought for a long time. To use a different name, overbought could simply be called strength. Despite the arguable nature of a stock being overbought, for trading purposes, when an indicator such as the RSI reaches extreme levels it can indicate a reversal is coming. After all, a sharp move can only sustain itself for so long before the buyers are exhausted ... at least for the short-term. As the S&P 500 SPDR (NYSE:SPY) has been creeping higher in 2012, these four stocks have exploded. With the aggressive moves lately, it is time to question if these stocks will keep running or see a pullback.
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Regeneron Pharmaceuticals (Nasdaq:REGN) saw a low on January 4 of $56.01 and currently trades at $78.92. The sharp rise is reflected in the overbought RSI indicator, which has a current reading of 84.55. Even just over the last year the stock has had its share of surges, followed by pullbacks. Two occurred in September of 2011 - the first moving to just under $75 and the next to just under $80. The pullbacks from those spikes were quite sharp. Therefore, as the stock hovers under $80, it is meeting resistance again. Short-term traders may watch for a shorting opportunity below Thursday's low at $77. Alternatively, if the top of a price gap which occurred between January 9 and 10 - $72 - is penetrated it would be a further signal the stock is now in retreat mode. Support comes in at $60 and $50. A rise above $80 could trigger another spike in price. (For related reading, see Introduction To Momentum Trading.)
Dun & Bradstreet (NYSE:DNB) has been on a march higher; the stock hit an intra-day low of $58.50 in October and has since risen to a current price of $78.78 - a near 35% gain from that low in a little over three months. This rise has pushed the RSI indicator to a reading of 80.63. This is a not a sell-signal, but it does indicate that a pullback is likely nearing. Volume has also been dropping (relative to prior price moves higher) in late December and throughout January as the stock moves aggressively higher. This too indicates the potential for a pullback. There is also a band of resistance overhead between $80 and $84. The current trend is up, though, which means a pullback could provide an entry point. The current upward sloping trendline intersects at $72.5 and provides a potential stop level for longs, or if the level holds, an entry point for new long positions. (For related reading, see Mastering Short-Term Trading.)
Westlake Chemical (NYSE:WLK) was trading around $41 at the beginning of 2012, and hit an intraday high of $55.65 on Friday, January 13. The RSI indicator is in overbought territory at 84.59; again, this is not a signal to sell, but it indicates that with the sharp move seen recently, a pullback could occur. Volume is rising with the surge in price, and this confirms the move higher. Of note is that the stock could not finish above $55 on Friday, and closed at $53.87. The $55 level has been resistance since June 2011, and it continued to be a troublesome level on Friday. A close above $55, plus a bit of time for the bulls to regroup at that level, could mean a higher price. If the stock can't get above that mark, there is little support until $44 followed by $37.50. (For related reading, see Day Trading: An Introduction.)
Chesapeake Midstream Partners (Nasdaq:CHKM) has been consolidating over the last several sessions, which has brought the RSI to just below 80 - 78.83. In late 2011 the stock was stuck near $27, but it saw strong moves in several sessions in late December and early January. Twenty-nine dollars had been strong resistance since late 2010, but it was finally broken by the recent price surge. Support is at $29, followed by $28 and $27.50. A pullback toward $29 could be a buying opportunity, as the stock has been ranging since the beginning of 2011, and the recent breakout indicates the stock could target $34. The consolidation over the last several sessions has also created a flag pattern, the breakout of which will reveal the short-term direction of the stock. (For related reading, see Introduction To Swing Trading.)
The Bottom Line
When an indicator, such as the RSI, gives an overbought reading it is not a signal to sell the stock. Rather, traders and investors should watch for reversal signals as an overbought reading can mean a pullback is near. The pullback may be a buying opportunity, or if there is little support it can indicate a big price drop. If there is strong resistance present and a stock is already overbought, the stock may present a shorting opportunity when the resistance can't be broken. (For related reading, see What Can Traders Learn From Investors?)
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At the time of writing, Cory Mitchell did not own shares in any of the companies mentioned in this article.