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.
Being overbought doesn't necessarily hurt a stock, because it could signal buyer interest as well as a profit point for the security's investors.
When a Stock is Overbought
There are only so many shares of stock 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 when they stop buying, 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.
Market Makers are Securities Dealers
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 for "Overbought"
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. Technical indicators take into account the volume of buys and sells in a stock, but technical indicators are only correct some of the time.
One technical indicator is the relative strength index (RSI). This indicator assigns 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. Traders typically use the RSI as a technical indicator, but individual investors typically use the price-earnings (P/E) ratio to measure a security's current value compared to its per-share earnings.
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.
Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.