The definition of overbought in trading means that the price of a certain security has risen faster compared to the underlying growth fundamentals of the security according to the investor’s opinion. Investors may use various key indicators to determine whether the security is overbought and make investment decisions accordingly.
How Overbought Works
You’re probably familiar with the phrase “buy low and sell high.” It is a timeless principle of successful investing and serves as a formula for making a profit in the market. Investors are faced with the task of determining when something is at a “low” or “high” price and often use fundamental and technical indicators. If an investor decides after analyzing the fundamental indicators that the security is overbought, they may wait for a more favorable buying price or perhaps short the security.
Overbought vs. Oversold
Overbought means that the price of the security is increasing rapidly compared to the underlying fundamentals. Whereas oversold means that the price of the security is decreasing rapidly compared to the underlying fundamentals.
What This Means for Individual Investors
Understanding when a security is overbought can be a vital sign for the investor in determining whether now is the right time to buy or sell the security. Investors can analyze the security’s financial data or chart patterns through sites like Yahoo Finance or through their brokerage’s website to get the necessary fundamental and technical indicators.
Investors should also be aware that overbought indicators do not guarantee future price movements of the security.
Frequently Asked Questions (FAQs)
How do you know when a stock is overbought?
A stock can be considered overbought when both fundamental and technical analyses indicate that the price is trading higher than usual. Common indicators used include the Relative Strength Index (RSI), moving averages, the price-to-earnings (P/E) ratio, and the price-to-sales (P/S) ratio.
What is the difference between an overbought stock and an oversold stock?
An overbought stock means that the price is increasing at a faster pace compared to the company’s underlying growth, while an oversold stock means that the price is decreasing at a faster pace compared to the company’s underlying growth.
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Sources:
Fidelity. “Relative Strength Index.”
Fidelity. “Moving Average Trading Signal.”
Source: https://www.thebalancemoney.com/what-is-overbought-in-trading-6834561
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