Overbought
Overbought is a term used when a security is believed to be trading at a level above its intrinsic or fair 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, but fundamentals may also be employed. A stock that is overbought may be a good candidate for sale.
The opposite of overbought is oversold, where a security is thought to be trading below its intrinsic value.
Definition
Overbought is a term used when a security is believed to be trading at a level higher than its intrinsic or fair value. Overbought typically describes recent or short-term price movements of a security and reflects the expectation that the market will correct the price in the near future. This belief is usually the result of technical analysis of the security's price history but can also be based on fundamentals. Overbought stocks may be good candidates for selling.
The opposite concept of overbought is oversold, which refers to a security believed to be trading below its intrinsic value.
Origin
The concept of overbought originated in the field of technical analysis, dating back to the early 20th century. At that time, technical analysts began using price charts and other tools to predict market trends. Over time, technical analysis methods evolved, and the concepts of overbought and oversold became widely accepted and applied.
Categories and Characteristics
Overbought conditions can be identified using various technical indicators, the most common of which include the Relative Strength Index (RSI), Stochastic Oscillator, and Bollinger Bands.
- Relative Strength Index (RSI): RSI is a momentum oscillator that typically ranges between 0 and 100. When the RSI value exceeds 70, it is generally considered to be in an overbought state.
- Stochastic Oscillator: This indicator determines overbought and oversold conditions by comparing the closing price to the price range over a specific period. When the indicator exceeds 80, it is usually considered overbought.
- Bollinger Bands: Bollinger Bands consist of three lines: a middle line (usually a moving average) and two outer bands. When the price approaches or exceeds the upper band, it may indicate an overbought condition.
Specific Cases
Case 1: Suppose a tech company's stock rapidly rises in a short period, and the RSI value reaches 75. Technical analysts might consider the stock to be overbought and expect a price correction. In this scenario, investors might choose to sell the stock to lock in profits.
Case 2: A retail company's stock price continues to rise over several weeks, and the Stochastic Oscillator shows a value above 85. Investors might believe the stock is overvalued and choose to sell or hold off on buying until the price corrects.
Common Questions
1. Does an overbought condition mean the price will definitely fall?
Not necessarily. While an overbought condition often suggests a potential price correction, market movements are influenced by various factors, and the price may continue to rise.
2. How can I avoid buying stocks in an overbought condition?
Investors can use technical indicators such as RSI, Stochastic Oscillator, and Bollinger Bands to identify overbought conditions and combine this with fundamental analysis to make more informed investment decisions.
