The Ultimate Guide to Overbought Conditions for Global Traders
You have seen it a thousand times before. A stock spikes 15% in just 3 days, it is the talk of the town, and you start thinking if this would be a good opportunity to buy or if you should avoid. This is where you can take advantage of understanding "overbought” conditions.
Let’s break it down in simple terms. When a stock or index is overbought, it has simply gone up too fast and too quickly. Like a rubber band, at some point, you have to figure that something is going to break. This does not mean that the stock is bad or that you need to panic sell. It means that the price of what many traders in the market deem reasonable has been eclipsed, and a pullback or correction is likely coming.
Why do these overbought situations occur? Two words: investor psychology. When rallies commence in the markets, a growing concern of missing out happens very quickly. This is not an unreasonable feeling, as there is a lot of FOMO (fear of missing out), if the underlying in the rally is relatively justified, more leads to more. Greed kicks in, and rational analysis goes out the window, and boom, you’ve got an overbought condition on your hands.
Core Definition: What Does "Overbought" Mean
Let's get away from the jargon. Overbought, in the technical sense, simply means that the momentum of the price has gotten ahead of itself. Most traders will gauge this by indicators that attempt to measure buying pressure and the velocity of price.
The most common and popular tool used? The Relative Strength Index, otherwise known as RSI. When RSI climbs above 70, that's when traders start to get anxious. Not because it means the stock is going to crash tomorrow, but because it means there probably has been a high enough volume of buying in a short amount of time that a pause or even a reversal is more likely to happen.
Overbought vs Oversold: Understanding Market Extremes
Financial markets behave like a pendulum, in that if they swing too far to one side or the other, the pendulum swings back in the opposite direction. Knowing the two sides of this spectrum, or at least two sides of it, helps you gain a great advantage in your investing.
Oversold is the mirror image of overbought, taking place as a result of panic selling, leading prices down quickly and excessively. When the stock or index price gets too low relative to recent price action, it becomes undervalued with a certain bounce expected. If overbought is an indicator of greed, oversold conditions are an indicator of fear.
Technical Indicators to Spot Overbought Conditions
ou can't trade what you can't measure. This is where technical indicators, such as RSI and the Stochastic Oscillator, play an important role by providing you with objective price momentum and potential extremes. We have already covered the implications of RSI in detail, but now, let’s discuss how to actually use RSI. Most trading platforms show RSI as a line graph below your price chart, oscillating between 0 and 100. You want to watch for this pattern: when RSI crosses above 70, make note of it. If RSI remains above 70 for multiple days while price continues to rise, the overbought condition is strengthening. When RSI returns below 70, you will have your first warning of a change in trend, if you are recognising the turn that is likely occurring!
The Stochastic Oscillator will give you a somewhat different view. It has a %K line that moves faster, and a %D line that moves slower. When both %K and %D lines are above 80, you have overbought conditions present. And here is the actionable part of this oscillating indicator: when %K crosses down through %D while both %K and %D lines are at 80 or above, you have a potential sell signal. The crossover simply means that momentum is starting to fade even while the price is still rising!
Using Overbought Signals Wisely
Knowing when a market is overbought won't make you a millionaire tomorrow, but you will see what mistakes could cost you a lot. You won't be chasing stocks at the worst possible time. You'll take your profits when everyone else is still being greedy. You'll manage your risk when you are trading with leverage.
Remember the most important lesson: overbought = pay close attention, but does not = you must sell it immediately. Look at the big picture. Look at the trend. Look at the volume. Look at the context of the market and then disengage emotionally, and assure yourself that you are making a decision to further your trading strategy.
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