# Identify Overbought Stocks: Meaning and Indicators Explained

## What Is Overbought?

Overbought describes a security trading above its fair value due to recent bullish trends. Both technical analysis and fundamental analysis may indicate these overstretched prices. Traders and investors use tools like RSI and P/E ratios to determine when a stock is overbought, potentially leading to a price correction.  

### Key Takeaways

*   Overbought describes a stock perceived to be priced above its intrinsic value, often signaling a potential price decline.  
    
*   Technical indicators like the Relative Strength Index (RSI) and Bollinger Bands help traders identify overbought conditions.  
    
*   A stock with a high P/E ratio compared to its sector may also be deemed overbought, using fundamental analysis.  
    
*   Overbought conditions may result from positive news that inflates buying pressure, pushing prices beyond reasonable levels.  
    
*   The interpretation of whether a stock is overbought varies among traders and analysts due to differing tools and methodologies.

## Overbought Explained

Overbought refers to a security which has been subject to a persistent upward pressure and that [technical analysis](https://www.investopedia.com/terms/t/technicalanalysis.asp) suggests is due for a correction. Bullish trends can result from positive news about the company, its industry, or the overall market. Buying pressure can increase, leading to continued bullishness beyond reasonable levels for many traders. In such cases, traders call the asset overbought and often predict a price reversal.

### Evaluating Overbought Stocks Using Fundamental Analysis

Traditionally, the standard indicator of a stock’s value has been the price-earnings ratio (P/E). Analysts use public results or earnings estimates to determine the right stock price. Investors may view a stock as overvalued and delay buying if its P/E exceeds its sector or index. This is a form of [fundamental analysis](https://www.investopedia.com/terms/f/fundamentalanalysis.asp), which uses macroeconomic and industry factors to determine a reasonable price for a stock.

### Identifying Overbought Stocks With Technical Analysis

Technical analysis lets traders use indicators to forecast stock prices. These indicators measure the recent price, volume, and momentum. Traders use technical tools to find overvalued stocks in recent trading and call them overbought.

Some traders use pricing channels like [Bollinger Bands](https://www.investopedia.com/terms/b/bollingerbands.asp) to spot overbought areas. On a chart, Bollinger Bands are positioned at a multiple of a stock's [standard deviation](https://www.investopedia.com/terms/s/standarddeviation.asp) above and below an [exponential moving average](https://www.investopedia.com/terms/e/ema.asp). When the price reaches the upper band, it may be overbought.

## Using RSI to Spot Overbought Stocks

Technical analysis has provided traders with increasingly sophisticated calculations to identify overbought stocks. George Lane’s [stochastic](https://www.investopedia.com/terms/s/stochasticoscillator.asp) oscillator, which he developed in the 1950s, examines recent price movements to identify imminent changes in a stock’s momentum and pricing trend. This oscillator laid the foundation for the technical indicator which has become the primary indicator of an overbought stock, the [relative strength index (RSI)](https://www.investopedia.com/terms/r/rsi.asp). The RSI measures the power behind price movements over a recent period, typically 14 days, using the following formula:

﻿ $\text{RSI}=100-100/\left(1+\text{RS}\right)$﻿

RS represents the ratio of average upward movement to downward movement over a specified period of time. A high RSI, generally above 70, signals traders that a stock may be overbought and that the market should correct with downward pressure in the near term. Many traders use pricing channels like [Bollinger Bands](https://www.investopedia.com/terms/b/bollingerbands.asp) to confirm the signal that the RSI generates. On a chart, Bollinger Bands lie one standard deviation above and below the exponential moving average of a stock’s recent price. Analysts that identify a stock with a high RSI and a price that is edging toward the high end of its upper Bollinger Band will likely consider it to be overbought.

## Case Study: RSI in Identifying Overbought Conditions

Here's an example of a chart with a high RSI reading that suggests overbought conditions:

![Image](https://www.investopedia.com/thmb/YcPz9hD_ureEmWVdxkMrcKCdlRw=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/dotdash_Final_Overbought_Sep_2020-013-385b6e73c3ce438e939375ab17150be1.jpg)

**

In the above chart, the oversold RSI conditions (below 30) predicted a rebound in the stock price in October. The overbought RSI conditions (above 70) in February could indicate that the stock will consolidate or move lower in the near-term.

## The Bottom Line

Overbought conditions occur when a security, stock, or asset rises beyond its fair value due to continuous upward pressure, suggesting a likely price correction. Investors can identify overbought stocks by using price-earnings (P/E) ratios and various technical indicators, such as the relative strength index (RSI) and Bollinger Bands. While the concept of "overbought" is subjective since different analysts use different methods, a high RSI score often indicates potential selling opportunities. Understanding the signals from both fundamental and technical analyses can help investors make informed decisions when considering market trends and stock valuations.