Analysts term a stock "overbought" when the stock reaches a point in trading where technical indicators suggest the next price move of the stock will be down. When a stock's price has risen too far, too fast and it is beginning to look expensive to investors, it is overbought. This is also a sign, however, that the stock did something good enough to attract a lot of investor attention.
There are only so many shares available for sale on the market at any one time. A stock price rises when there are more buyers than sellers. Eventually, a stock will reach a price point that buyers think is too high, so they stop buying and traders start to take profits. When sellers outnumber buyers, the price of the stock declines. When profit taking starts, it is called the stock's resistance point, and that is what analysts try to predict when they say a stock is overbought.
When buying interest is heavy, a market maker can fill a buy order with shares he doesn't own. He sells the stock short. The market maker must cover those sales by purchasing shares later, but he doesn't mind because probability indicates the stock will correct down in price when it becomes overbought enough. When the stock corrects, probability says it will test its technical support, which is where buyers think it has value. That's where the market maker buys back in -- when the stock is oversold.
Technical analysis is a process of determining how much stock is in the market and applying statistical analysis and a little psychology to figure out how the active traders feel about their stock positions. The relative strength index and other technical indicators take into account the volume of buys and sells in a stock and assign an index level that reflects the approximate mood of the market. If the RSI is above 70, it is said to be an indication that the stock is overbought, but technical indicators are only correct most of the time.
Good and Bad News
If good news about the company comes into the market, it can trigger enough buying interest to drive an overbought stock up through resistance, making it more overbought. However, if the good news had been anticipated, the release of that news is also likely to trigger profit taking. So, the fact that a stock is called overbought is not necessarily proof that it will decline in price, but it is a good time to consider taking profits on part or all your position.
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