DEFINITION of 'Overbought'
Overbought refers to a situation in which the demand for a certain asset or security unjustifiably pushes the price of that asset or underlying asset to levels that are not justified by fundamentals. Overbought is often a term used in technical analysis to describe a situation in which the price of a security has risen to such a degree - usually on high volume - that an oscillator has reached its upper bounds.
BREAKING DOWN 'Overbought'
An asset being overbought can be explained by an almost constant upward trend in the price of an asset that exhausts all the buyers for the asset. As a result, the asset becomes vulnerable to a price reversal because all those who wanted to buy it likely already have it and supply forces may start to outweigh demand forces leading to selling pressure on the asset. On the fundamental level, an asset may be overbought if demand for it has made its future cash flows discounted back to the present not justify the asset's current price.
When an oscillator reaches its upper bound, it is generally interpreted as a sign that the price of the asset is becoming overvalued and may experience a pullback. An asset that has experienced sharp upward movements over a very short period of time is often deemed to be overbought. Determining the degree to which an asset is overbought is very subjective and can differ between investors. Technicians, practitioners of technical analysis, use indicators such as the relative strength index (RSI), the stochastic oscillator or the money flow index to identify securities that are becoming overbought. An overbought security is the opposite of one that is oversold.
The RSI compares prior trading sessions' average gains versus average losses. Like other statistical measures, as the number of sessions used in the calculation increases - the more accurate the RSI measure becomes. An RSI value of 80 or above indicates that an asset is overbought, showing that the asset in question has sustained higher and higher prices for a long period of time. Contrarily, an RSI value of 30 or below indicates that an asset is oversold.
The stochastic oscillator compares the current price of an asset to its price range in prior trading sessions. When a stock frequently closes near its highs, it is considered to be in an uptrend; when it frequently closes near its lows, it is considered to be in a downtrend. If the stock's price starts closing away from either its highs or lows, it is considered a weakening of either an up- or downtrend. Like RSI, a stochastic oscillator value of 80 or above indicates that an asset is overbought, while levels of 20 or lower indicate that an asset is oversold. The money flow index also evaluates whether an asset is overbought or oversold by analyzing the selling or buying pressure on the asset; it does this by considering the price volatility of and volume of trading in the asset.