What is Overbought
Overbought refers to a security that analysts or traders believe is trading above its true 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.
BREAKING DOWN Overbought
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 may be due to positive news regarding the underlying company, its industry or the market in general. Upward movement can feed on itself and lead to continued bullishness beyond what many traders consider reasonable. When this is the case, traders refer to the asset as overbought and many will bet on a reversal in price.
Traditionally, 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. If a stock’s P/E rises above that of its sector or a relevant index, investors may see it as overvalued and as a smart buying opportunity for long-term investing. This is a form of fundamental analysis, which uses macroeconomic and industry factors to determine a reasonable price for a stock.
The rise of technical analysis has allowed traders to focus on indicators of a stock to forecast price. Indicators include recent price, volume and momentum. Traders use technical tools to identify stocks that have become overvalued in recent trading and refer to these equities as overbought.
Technical Analysis Tools for Identifying Oversold Stocks
Technical analysis has provided traders with increasingly sophisticated calculations to identify overbought stocks. George Lane’s stochastic oscillator, which he developed in the 1950s, examines recent price movements to identify imminent changes in a stock’s momentum and pricing trend. This oscillator laid the foundation 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, using the following formula:
RSI = 100 - 100/(1 + RS)
RS represents the ratio of average upward movement to downward movement over a specified period of time. A high RSI, generally above 70, signals traders that a stock may be overbought and that the market should correct with downward pressure in the near term. Many traders use pricing channels like Bollinger Bands to confirm 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.