Overbought: Understanding the Meaning and Techniques to Identify Overbought Stocks

Overbought: Understanding the Meaning and Techniques to Identify Overbought Stocks

What is Overbought?

When a security is considered to be trading above its intrinsic or fair value, it is said to be overbought. This typically refers to a recent or short-term movement in the security's price, and suggests that the market is likely to correct the price soon. The determination of overbought status often involves technical analysis of the security's price history, although it may also take into account fundamental factors. A stock that is deemed to be overbought may present an opportunity for selling.

The antithesis of overbought is oversold, which is used to describe a security that is believed to be trading below its intrinsic value.

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Key TakeAway
  • An overbought security is one whose price is believed to have exceeded its true worth.
  • A number of investors rely on price-earnings (P/E) ratios to gauge whether a stock is overbought, whereas traders use technical tools such as the relative strength index (RSI) to assess market conditions.
  • Evaluating an asset's market price against its intrinsic value through the analysis of financial statements or underlying factors is another application of fundamental analysis.
  • At the end of the day, the definition of overbought is open to interpretation and can vary depending on the tools and methods employed by individual traders and analysts. One person's overbought asset may be another person's opportunity to profit.

Overbought Explained

Overbought describes a security that has experienced a sustained upward movement and technical indicators suggest a pullback or correction is imminent. This bullish trend may be driven by positive news related to the underlying company, industry, or the broader market. As buying pressure continues to build, it can drive the price higher than what many traders believe is justified. In such cases, traders consider the security to be overbought and often place bets on a potential price reversal.


Fundamentally Overbought

The conventional way of evaluating a stock's worth has been by using the price-earnings ratio (P/E), which has been used by analysts and companies to determine the fair value of a stock by either using reported results or earnings projections. If a stock's P/E surpasses that of its industry or relevant index, investors may view it as overpriced and avoid buying it at that moment. This is a type of fundamental analysis that employs macroeconomic and industry factors to determine a reasonable stock price.

Technically Overbought

The emergence of technical analysis has enabled traders to concentrate on stock indicators to predict prices. These indicators assess recent price movements, trading volume, and momentum. Traders utilize technical tools to pinpoint stocks that have experienced a surge in value in recent trading sessions and describe these equities as overbought.


Certain traders employ price channels such as the Keltner Channel to identify overbought regions. The Keltner Channel is a technical analysis tool that is based on an exponential moving average, an average true range, and an upper and lower band. When the price reaches the upper band of the Keltner Channel, it may be considered overbought.

How to Identify Overbought Stocks with RSIThe use of technical analysis has given traders access to advanced tools to identify overbought stocks. One of the earliest indicators, developed in the 1950s by George Lane, is the stochastic oscillator. This oscillator analyzes recent price movements to detect potential shifts in a stock's momentum and pricing trend. The stochastic oscillator served as the basis for the relative strength index (RSI), which is now the primary indicator used to identify overbought stocks. The RSI gauges the strength of price movements over a selected period, usually 14 days, using a specific formula:

RSI = 100 – 100 / ( 1 + RS )


The RS index is calculated by comparing the average upward movement to the average downward movement over a specific period of time. A high RSI, typically above 70, is a signal to traders that a stock may be overbought and that the market should correct with downward pressure in the short term. To confirm this signal, many traders utilize pricing channels like Keltner Channels. These channels are plotted based on the Average True Range (ATR) and an exponential moving average (EMA). When the price moves outside the Keltner Channel, it may indicate that the stock is overbought. Traders who notice a high RSI and a price that is approaching the upper Keltner Channel will likely consider it to be overbought.


Example of Overbought Conditions Using RSI

Below is an illustration of a chart that demonstrates an RSI reading that is high, indicating overbought conditions:


In the chart shown above, the RSI signaled oversold conditions (below 30), which accurately predicted a rebound in the stock price in October. However, the RSI's overbought conditions (above 70) in February could suggest that the stock is likely to experience consolidation or downward pressure in the short term.

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