Overbought stocks is a common term in the stock market, that is often used to describe stocks that are being bought up by investors. But what does it actually mean? And more importantly, what should you do about it if you're holding or considering buying overbought stocks?
In this article, we will answer all of those questions and more.
What does overbought mean in stocks?
Overbought simply means that a stock is trading at a level that is higher than what some investors believe is warranted by the underlying fundamentals of the company.
This can be due to a variety of reasons, such as positive earnings surprises, analyst upgrades, or even just general market momentum. If too many investors bought into a stock over a short period of time and the outlook does not match the buying pressure, it can be often described as overbought.
Value investors will use this term if a stock is trading at a price that is higher than its intrinsic value. On the other hand, growth investors may believe that stock still has room to run even if it is considered overbought by value standards.
Overbought can mean 'stay away' for some conservative investors. But those that are aiming for the best-case scenario might be willing to buy into stock even if it's considered overbought, to take advantage of a bullish trend.
What is an overbought stock?
In simple terms, overbought is just a term used to describe a stock that has had too many buyers to match its future outlooks. It might still have the potential to run up, but based on the information known at the time, it appears to be an overvalued stock.
Is overbought bearish or bullish?
While overbought can be seen as a signal for a potential reversal, it doesn't necessarily mean the market will reverse. Rather, it is an indication that the market is due for a period of consolidation or correction.
If a stock is overbought, traders might notice this and decide to sell, causing a bearish trend. However, FOMO (fear of missing out) can take over and the overbought signal can persuade more buyers to enter the market, leading to a bullish trend.
Therefore, overbought is neither definitively bullish nor bearish, but it can be seen as a sign that the market is due for some selling pressure.
What happens when a stock gets overbought?
If a stock is overbought, what typically happens is profits get taken. The reason why is because when a stock is overbought, it means that it has reached a level where most of the buying has been completed and there aren't many new buyers left to push the price higher.
Basically, when a stock is overbought, you might see a sell-off. This isn't always the case but it makes it tempting to take profits for some traders and less tempting for new investors to enter a position.
If something is overbought, it might still have some room to run in the short term, but if the news doesn't quickly match the price, you might see a sharp decline.
What makes a stock overbought?
As mentioned earlier, what makes a stock overbought is when too many buyers enter the market and push the price higher than what is warranted by the underlying fundamentals of the company.
Whether it be due to news that is perceived as more bullish than it truly is, or long-term FOMO, overbought stocks are typically driven by momentum rather than fundamentals.
To classify an overbought stock, investors and traders will use a variety of technical indicators. If you aren't a trader, you can speculate but you don't know for sure.
The most common indicator used to signal that a stock is overbought is the Relative Strength Index (RSI).
Let's explore how this technical indicator helps to identify overbought stocks in more detail.
How to tell if a stock is overbought
There are a few different ways to measure whether a stock is overbought. If you are a technical trader, one popular method is to use the Relative Strength Index (RSI).
Relative Strength Index
The RSI measures how much a stock has risen or fallen over a given period of time, and it assigns a numerical value to that movement. A stock is typically considered overbought when the RSI reaches 70 or above. If you see this occurring, it's a clear indication that the stock has been bought up too quickly and it may be time to take profits.
Another way to measure whether a stock is overbought is to look at its price relative to its moving averages.
Moving average
If the stock's price is significantly higher than its 200-day moving average, it may be considered overbought.
The moving average is a good measure of a stock's long-term trend, so if the stock is trading well above that average, it may be due for a pull-back. By looking at historical averages and comparing them to short-term price action, traders can get a good idea of whether a stock is overbought.
Should you buy or sell an overbought stock?
This depends on if you have faith in the company and management. An overbought stock is not necessarily a bad thing. If you are a long-term investor, you may want to hold on to the stock and see how it progresses.
There is a popular stock market expression that states that nobody ever went broke taking profits. So if you are a short-term investor, you may want to sell and realize some gains.
There are a few things to consider before making a decision:
The market
Is the overall market overbought or just a particular sector or stock? If the entire market is overbought, it may be time to sell everything and wait for things to cool down. With that being said, timing the market is difficult and you may miss out on some gains if you wait too long.
The market might continue being bullish for many years, despite being overbought in the short term.
The company
Do you have faith in the company’s management? Or do they show signs of incompetence? If a business is overbought and has poor management, it may be a good time to sell.
Your personal finances
How much cash do you have on hand? If you don't have a lot of cash, you may not be able to take advantage of opportunities when the market corrects. On the other hand, if you are not in a position that requires liquidity, holding on to overbought stocks may be a good idea for long-term growth.
These are just a few things to consider when trying to determine if a stock is overbought. As with anything in investing, the key is to do your research on the company before making any decisions.
Is overbought or oversold better?
Typically, it's better to enter into a position when an asset is oversold. The reason for this is simply because there is more potential for the asset to go up than down. When an asset is overbought, there is a greater chance that it will start to go down.
Of course, there are exceptions to every rule. However, when something is oversold, it means that fear has entered the markets, and investors are letting go of assets not based on fundamentals, but on emotion. This provides an opportunity for the savvy investor to swoop in and buy up assets at a discount.
Investors need to be careful, however, as oversold conditions can sometimes lead to a bear market. This is when the overall market starts to go down and it becomes difficult to make money in the markets. With that in mind, oversold does not automatically mean 'buy' it just means that an asset is more likely to be undervalued.
If you are looking to exit in a position and claim some profits, an overbought stock presents an opportunity to do so. This is because the stock may be due for a pull-back and you can sell before the price starts to drop. Again timing the market might not be easy for some investors. But technical traders that can identify overbought stocks can take advantage of these conditions.
Conclusion
Overbought stocks just represent the high demand investors have for them. Too many people are buying and the stock price is too high. This doesn't mean that you should automatically sell your shares. Instead, take a step back and evaluate the situation.
Consider the market conditions and the company before making any decisions. If you believe that the stock is still a good investment, then hold on to it. However, if you are looking to take profits, an overbought stock presents an opportunity to do so.
If you want to enter a position but it is overbought, you can choose to wait and see if the price corrects or the stock goes down. However, some overbought stocks remain that way for years to come.
Even with more buyers than the fundamentals warrant, the stock price might not fall. This mentality can prevent you from ever owning equity in a strong growth company.
But if you are a value investor, chasing an overbought stock is usually not a good idea. Remember that you are looking for undervalued assets and overbought means that there is less growth potential. Oversold stocks, on the other hand, might just be undervalued and present an opportunity to buy low and sell high.