The term “overbought” is used to describe a stock or market that has advanced or reached a point, from where it historically retreated or moved lower. To identify overbought conditions in markets, traders and investors use technical indicators known as oscillators.
How a share trader can identify overbought stocks
Also, we can say that overbought is a situation, where investors have bought the stock abundantly, and now the stock is seeking to take a reverse and move to a lower price.
How to identify such stocks?
Oscillators basically predict or analyse the sentiment of investors for discovering “too much buy” or “too much sold” condition in the market. As the value of the oscillator’s approach the upper-end of the band then the asset is deemed to be overbought, and as it approaches the lower-extreme, it is deemed to be oversold.
The Relative Strength Index (RSI) is of the widely used oscillators for identifying overbought conditions. The RSI is a price-following oscillator ranging between 0 and 100. It is a kind of mathematical measure that can point whether a particular stock is overbought or oversold.
The Relative Strength Index is one the financial technical analysis momentum oscillator measuring the velocity and magnitude of directional price movement by comparing upward and downward close-to-close movements. It was initially introduced in June, 1798.
The above graph is an example of Relative Strength Index (RSI). Here we define a fixed border separating overbought and oversold area from “normal” or “neutral” market conditions. The borders typically lie between 30 (blue line) & 70 (red line).
Also Read : Use Fundamental Analysis to Select Right Stocks
RSI can be interpreted as follows:
- When RSI is between 30 and 70, the market is said to be in a neutral area. This is a dull part of an RSI chart as neither buying nor selling forces price to jump to any side of the band, and price action are more or less move in sideways.
- When RSI touches its extreme top band or it is greater than 70, it signals overbought situation. This generally happens in an uptrend, when the bulls are more dominating than the bears.
- When RSI is below 30 or touches its extreme low band, then the market is said to be oversold. This phase reflects that bears have more strength. The trend is said to be downward.
An example to help you understand better
The above graph shows the RSI index in the lower part and the trading chart above. For Instance, if we consider the 9-month candlestick chart of Jai Prakash Associate, one of the most popular stocks on NSE, we get know that Jai Prakash Associate was trading around at a price of 88 in the beginning of June 14 with an RSI around 70-80, this indicated that the stocks is highly ‘Overbought.’ Once the RSI retreated the 70 band on 10th June, and gave a breakout below, the stock price, also, fell from 88 to 70 and lower within a matter of few days.
How it is helpful?
Along with some smart moves and good investing decision, an investors can gain a good profit or reduce exposure, if he/she analyse the stock for an overbought scenario. Though some risks are involved (which can never be diversified), but overbought condition help investors in the following ways:
- Right entry for creating short Position: Identifying overbought position help investors to create short-position and enjoy a good amount of profit. In general, all stocks certainly follow this technical provided there is no fundamental reason to hold the stock for a long-term benefit.
- Identifying Market trend: Studying Relative Strength Index help investors to know the position of the markets, whether it is moving in uptrend or downtrend. Knowing the market will help the investors to gather information on any short-interest presently available or to come their way in the future.
- Neglect wrong choice of stock: Also, many times identifying overbought situation help investors to avoid wrong position in the stock.
Relative Strength Index is very helpful, as it helps a trader to know the time to make an entry or exit, in the stock. There is one more thing investors should know that the stock can trade above or below the bands for any numbers of days, sometimes even months. RSI oscillator’s only gives a scenario that the stock is expected to fall back as it reached a level where investors have bought the stock in abundant, but there is possibility that the company comes up with some good news and the stock turn to be a hot pick for a day or a week, making it trade over the band.