Overbought: meaning and how it works [Guide]
We can define Overbought as a level reached by a company that exceeds expectations, or there is news to support the stock and an increase in purchase demand is triggered, which cannot always be explained by the fundamentals.
As the volume of purchases increases, the positive sentiment of investors stimulates even more the increase in prices and if the market believes that the latter are not justified by the real value of the company, we are in a situation of overbought.
Let’s see what characterizes this situation:
- A stock with a price above its intrinsic value is called overbought.
- You can use the price / earnings ratio (P / E) to determine if a stock is overbought in fundamental analysis, while indicators are used in technical analysis.
- Overbought is a subjective term, it is not definable in an absolute way.
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Overbought: what is it
We gave you a very general explanation, but now let’s try to better explain what it is.
When we say that a stock is overbought, there is a feeling that it is trading at a value higher than its real value. Let’s talk about sensation because the trading indicators that show this condition are not 100% effective. A stock can be overbought for one indicator and not don’t for another.
Usually an overbought condition should show a precarious, short-term condition that should rebalance itself, but this is not always the case.
The expectation of traders, when they see an overbought condition, is that the stock reverses its march and at least retraces if not a real trend reversal.
The overbought condition does not mean that you have to rush to sell the stock but only that prices have risen too quickly and a correction is expected.
Overbought and Oversold
The opposite of an overbought stock is an oversold stock.
The two extremes show two limit situations for a trend, which is found to be excessively bullish or too bearish, if we compare it with the real value of the security analyzed.
How to use Overbought
The overbought condition, to be visible and consequently “exploitable” must be shown by one or more indicators in a trading platform.
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Trading with overbought
Price and value are two very different things. Price is what you spend on something, value is what you get in return.
There is also this difference in the markets and it can be very high. In trading, when a stock trades above its intrinsic value, it is called overbought.
As we have said, this condition is “subjective” and to be confirmed you need the fundamental analysis that calculates, for example, the price / earnings ratio. Or the technical analysis that uses some indicators instead.
The most used technical analysis indicator to verify an overbought condition is the RSI: the Relative Strength Index.
The strategies that are based on overbought are complex but there is always a good indicator at the base, usually an oscillator that switches from signaling the overbought condition to the oversold one and one or more confirmation indicators.
As we have said, the RSI oscillator has become the main indicator of an overbought stock and is difficult to replace, when the RSI rises and breaks out of the 70 line, it is entering the overbought zone.
At this point, a trader looks for confirmation, usually given by a Moving Average, a crossover or another indicator and evaluates whether there could be a reversal or a retracement.
Many traders use price channels such as Bollinger Bands to confirm the signal generated by the RSI.
If a stock has an RSI above 70 and is approaching the upper limit of the channel formed by the Bollinger Bands, it is probably in an overbought condition.
To define an overbought situation in Technical Analysis some indicators and some rules are used, let’s see the most important:
As we have repeated several times, the RSI is the main indicator that shows an overbought situation on a technical analysis chart.
In a 14-period setting, readings above 70 are considered overbought.
Below we see an example of a RSI signal over 70 that heralds a reversal of the trend:
In Intraday Trading or in any case short-term trading, the RSI setting can be changed to capture more signals. In this case the overbought condition can trigger over 90 instead of over 70 points to filter out false signals.
Another way of discovering overbought situations is to count the number of consecutive bullish days to get an idea of how much a market has risen.
For example, you can consider an overbought stock when prices have risen for 8 consecutive days.
Obviously this is not a fixed number, it depends on which stock or market we are considering and its historical trend.
Bollinger Bands, which as we have seen can be used as confirmation, also have the possibility of showing an overbought situation.
When a stock’s price rises above the upper Bollinger band, we could say we are overbought.
Here is an example below:
Overbought and oversold are two sides of the same coin, whichever indicator shows one, usually will also show the other.
This is why these indicators are called oscillators. Because they range from overbought to oversold, swinging between two extremes.
Let’s see the main oscillators showing these conditions:
We have already spoken several times about the RSI or Relative Strength Index so we will not go further.
Let’s simply say that this is probably the most effective indicator for evaluating overbought situations in technical analysis.
Money Flow Index
The Money Flow Index is very related to the RSI but it also measures volume as well as prices.
This makes it a very accurate indicator but one that can provide very different overbought indications than the RSI.
It is a momentum indicator that measures the amount of money that enters and exits a market.
The CCI or Commodiy Channel Index is an oscillator born for commodities but which is now used in every market.
It clearly shows the cycles of a stock and identifies overbought (or oversold) conditions with some precision.
The CCI evaluates the strength of the trend and allows you to predict when a stock no longer has the “momentum” to continue.
The Stochastic Oscillator allows you to identify the momentum in the price and its acceleration.
The formula shows the fluctuations between 0 and 100 and therefore also clear signals of overbought or oversold, which must in any case be confirmed by at least one other indicator.
The overbought methods and indicators that we have shown in this guide are not easy to apply, it takes a lot of practice and a certain sensitivity to understand when they are giving useful signals or when it comes to “false signals”.
When a stock is overbought, it often does not stop rising and if the trend is strong it can remain “overbought” for a long time.
This is why it always takes a strategy and a combination of indicators to trade, you don’t have to trust a single indicator to enter and exit the market.
Although overbought levels have limits when it comes to signaling market entry, they are much more effective for exiting.
If you are bullish in a trend, a clear overbought level can signal a likely reversal well in advance, so you shouldn’t underestimate these indications.
In conclusion, we can say that overbought measures if a stock has been bought for too long and has reached a price level that is difficult to sustain.
The methods and indicators that show these conditions are very different and can produce different results. But the best way to exploit this situation is to use more indicators and more methods, so as to have more confirmations and filter out false signals.
There are many strategies that are based on overbought conditions but before putting them into practice it is advisable to study the most used indicators to show these situations.
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In addition to theory, you need a lot of practice to learn how to deal with complex overbought situations.
You can’t risk your money while learning to use indicators and oscillators, that’s why there are Demo accounts.
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This is a situation where the price of a security is higher than its real value.
In addition to the RSI there are several oscillators that show overbought situations. In our guide we show the main ones.
The strategy, whatever it is, must include at least one confirmation indicator. For more details read our guide.
A trading platform is enough, better if provided free of charge by a CFD Broker like eToro, safe and without commissions.