What is an overbought condition?

Posted on Thursday, April 25th, 2019 MarketBeat Staff

Summary - One of the most anticipated events on the financial calendar is earnings season. This is the time when a company announces how it performed in terms of revenue (the topline) and earnings per share (the bottom line) as compared to analysts' predictions. When a company beats expectations, particularly if the beat is significant, it typically triggers increased buying demand. As buying volume increases, positive investor sentiment spurs, even more, buying as investors experience the fear of missing out (FOMO). As buyers outweigh sellers, the price of the company's stock rises. 

However, when the market suspects that the market has begun to trade at a price above its intrinsic value, the stock is then said to be overbought. When analysts state that a stock is overbought it does not mean that the stock is a bad stock. It does mean, however, that the stock may not be a good value at that price.

The opposite of an overbought stock is an oversold stock. This, as the name implies, reflects a stock that appears to be worth more than the price it is trading at. Like an overbought stock is not necessarily bad, the existence of an oversold condition does not mean that the stock is a good stock. It simply means that the stock is generally seen as a good value at this particular time.

There are many ways for investors and traders to spot a stock that is overbought. One of the primary fundamental indicators is the price/earnings (P/E) ratio. By comparing the P/E ratio of an individual stock with stocks within the sector or stocks that have a similar market capitalization, investors can determine if a stock is overbought.

The growth of technical analysis has given rise to other indicators that can help confirm an overbought condition and help traders make investment decisions. One of the most commonly used is the Relative Strength Index (RSI). The existence of overbought or oversold conditions can be more easily visualized in when viewed with confirmed levels of support and resistance. For this reason, traders often use other technical indicators including Bollinger bands and the moving average convergence/divergence (MACD) oscillator as a way of fine-tuning their trading strategy. 

One of the concerns about a stock being overbought is that even if traders confirm an overbought condition, the stock may not correct as planned. It is possible that investor sentiment can spur a stock to higher and higher levels.

Introduction

There is a difference between price and value. Price is what you pay for something. Value is what that item is worth. This is also thought of as its intrinsic value. In investing, when a stock or security is trading above its perceived intrinsic value, analysts will call it overbought. A common reason for a stock to be overbought is shortly after the release of good news. Shares of a company's stock can rise quickly on positive news such as when the company reports favorable earnings, launches a new product or announces a dividend. However, what goes up will go down. In the world of investing, stocks can reach a point defined in technical analysis as being overbought. When a stock is overbought, it is a signal to traders that the security is ready for a correction. In this article, we’ll take a closer look at what is meant when a stock is in an overbought condition, how a security becomes overbought, and how investors and traders can confirm an overbought condition. We’ll also discuss why overbought signals do not always indicate an imminent correction.

What is an overbought condition?

When a security is said to be overbought it is said to be trading above its intrinsic value. An overbought condition is said to reflect a short-term trend of price movement. The expectation, though not always the reality, for an overbought stock is that it will turn downward. Although overbought means a stock is reflecting a bullish trend it should not be taken as a predictor of the broader stock market. A security can be overbought whether the stock market is in a bull market or a bear market. By itself, the condition of a stock being overbought does not mean that investors should not own the stock. It does suggest, however, that it may be a time to take some profits and wait to buy more shares when the stock price moves lower.

The opposite of a stock being overbought is a stock that is oversold. An oversold stock is a stock that is trading at a discount to its intrinsic value. Using the same logic of an overbought stock, the fact that a stock is oversold does not mean it is an underperforming stock.

One of the common ways to notice trends for stocks that are overbought or oversold is by looking for support and resistance levels. Support levels indicate a low price level that a stock does not move below. A resistance level is a price level that a stock does not move above. When a stock trades between clear lines of support and resistance, it is said to be trading in a range. Rage trading can be a very profitable trading strategy that is based on buying and selling overbought and oversold stocks.

How does a security become overbought?

Any security can experience an overbought condition. For example, crude oil and gold are two assets equities other than stocks that experience frequent price movement that is based on investor sentiment. However overbought and oversold are terms frequently discussed in terms of individual stocks.

For every stock, there are only so many outstanding shares available for public trading. A stock becomes overbought when there are more buyers than sellers in a compressed time frame. When there is good news about a stock, it can cause the shares to experience rapid price movement above its intrinsic value. As we stated earlier, when analysts declare that a stock is overbought it does not mean that the stock is underperforming. It is a notion of value.

How is an overbought condition confirmed?

An overbought condition can be confirmed through fundamental analysis or technical analysis. Investors who practice fundamental analysis will use a stock’s price-to-earnings (P/E) ratio. Investors will look at a stock’s P/E ratio in context with other companies in its sector. If the stock has a P/E ratio that is significantly higher than others in its sector, it is usually a sign that a stock is overbought.

Traders will use technical indicators such as the Relative Strength Index (RSI) to confirm an overbought condition and then plan trades accordingly. The RSI for a stock is a measure of volatility and expresses a ratio of the average upward movement to the average downward movement over a specific period of time, typically 14 days. An RSI reading above 70 indicates an overbought or bearish indicator. An RSI below 30 is seen as an oversold, or bullish, indicator. When a security is in an uptrend, the RSI will tend to stay above 30 and should frequently rise to 70 or above. This is because when a stock is overbought buyers outnumber sellers so traders would expect a security to show more gains than losses. Conversely, when a stock is exhibiting undersold conditions, the RSI will stay below 30 and only occasionally rise to 70. When a security is in a downtrend, the index should show more lows than highs. The key takeaway is that RSI is a measure of volatility and momentum, not price movement.

 Traders use charting software to overlay the RSI, along with other technical indicators, on a daily chart. Other technical indicators that traders use in conjunction with the RSI to identify overbought/oversold conditions include:

  1. Bollinger Bands– these are bands that are plotted one standard deviation above and one standard deviation below a security’s exponential moving average. A security that is selling near the high end of the upper Bollinger band and has a high RSI is usually considered overbought.
  2. Fibonacci Retracement Levels– A Fibonacci retracement level is identified by taking an extreme high and low on a stock chart and dividing the distance between the two (visually this will be the vertical distance) by the key Fibonacci ratios (23.6%, 38.2%, 50%, 61.8%, and 100%). These levels will then be defined on a chart by horizontal lines that indicate potential areas of support and resistance. It is unclear why the Fibonacci ratios are such a consistent predictor of stock price movement only that they are.
  3. Moving Average Convergence/Divergence Oscillator (MACD)– The moving average convergence/ divergence oscillator shows the relationship between two exponential moving averages (EMAs). The most common moving averages used are the 26-day moving average as the longer average and the 12-day moving average as the shorter average. By subtracting the longer average from the shorter average, the MACD displays both the trend of the price action for the underlying security as well as the momentum of buying and selling activity. The companion to the MACD line is a signal line which is the 9-day EMA for the asset being used. The MACD is a momentum oscillator that moves above or below a center line (also called a zero line). Traders will look for signal line crossovers, centerline crossovers, and divergences between the MACD line as triggers for buying and selling.

Are overbought indicators always correct?

Like any technical indicator, overbought indicators such as the RSI are not infallible. There are times when investor sentiment will spur the price of an asset to even higher levels. That doesn’t mean there won’t be a correction eventually; it just means that even the most accurate indicators such as a well-defined resistance level may not create the price movement traders are looking for at the moment they are looking for it to happen. However, it is generally a good indication that it may be an ideal time for profit-taking even if that means an investor may miss out on short-term price movement. When traders see evidence of a stock continuing to extend gains despite evidence of being overbought, they can set trading stops at progressively higher levels to help ensure they lock in profits while ensuring they exit trades before the stock undergoes a correction.

The final word on overbought conditions

When a stock or security is described as overbought it is referring to a condition where a stock has gone too far in a positive direction and both fundamental and technical indicators are suggesting that the stock is set for a correction. This is a selling signal. The opposite of a security being overbought is one that is oversold. This indicates a security that is displaying indications that its price is trading at a discount to its intrinsic value. This is a buying signal.

When a security is overbought it does not mean that it is underperforming but rather that it is in a period where it is selling for more than analysts perceive as its intrinsic value. Analysts seek to find the sweet spot between price (which is the dollar amount investors pay for a security) and value (what that security is actually worth).

To determine an overbought condition, investors who practice fundamental analysis will look at the price-to-earnings (P/E) ratio which provides a side-by-side comparison of two comparable stocks (same sector, market cap, etc.). Traders, particularly day traders, will look at technical indicators to help them define their trading strategies. One of the most common indicators is the Relative Strength Index (RSI) which helps to show the momentum and volatility surrounding price movement. When the RSI is used with other technical indicators it can provide further confirmation of overbought conditions.

The indication of an overbought condition does not mean the stock is certain to rise in price. Stocks can rise and/or fall for reasons that defy market expectations. Many times the fear of missing out (FOMO) effect can lead to a security experiencing a period of “irrational exuberance” that may carry the stock to even higher highs. In this case, traders may still find it a good strategy to take some profits and set trading stops at progressively higher levels.

 

Enter your email address below to receive a concise daily summary of analysts' upgrades, downgrades and new coverage with MarketBeat.com's FREE daily email newsletter.

Yahoo Gemini Pixel