Overbought stocks refer to the actual value of a company or an asset compared to its market value; they are those that trade at a price above their intrinsic or fair value. It's typically expected that the market will correct and they will move lower. On the opposite end of the spectrum, oversold stocks trade below their true value and should rise higher.
In some situations, stocks, exchange-traded funds (ETFs), options, forex and commodities can stay overbought or oversold for a while prior to a reversal.
In this article, we'll take a look at overbought stocks and analyze the environment for overbought stocks. We'll also explore why or why not overbought stocks may make a good investment. We'll also help you analyze several examples of overbought stocks as well.
There's a lot to learn about overbought stocks, so let's get going. By the time you're done reading, you'll have a better idea of how to handle overbought stocks and whether you should attempt to trade them yourself.
What Are Overbought Stocks?
As mentioned before, overbought stocks are those that trade at a level above fair value. When a stock becomes overbought, it's heading for a retreat — they tend to rubber band back after they get too far away from their longer term trend line. Recent or short-term movement in the price of the security shows that it's likely that the price will correct in the future. You can use different forms of analysis to learn estimates of a stock’s value.
When you engage in technical analysis, it involves identifying trends and patterns through charts in order to evaluate investments and trading opportunities. Overbought stocks can be fundamentally overbought or technically overbought. You can identify technically overbought stocks based on price action and historical data rather than fundamental analysis. Fundamentally overbought stocks can be identified based on the company's financial statements.
How to Tell if a Stock is Overbought
How can you tell if a particular stock is overbought?
You can use the Relative Strength Index (RSI), one of the most common ways to measure price momentum. The RSI is a momentum oscillator which measures the speed and change of price movements. The RSI ranges from zero to 100 and you can determine whether a stock is either overbought or oversold by charting the ratio of these higher closes to show you the velocity of the move.
When the RSI becomes overbought, the price rises too high too quickly, which usually leads to a downside correction. On the flip side, when it becomes oversold, the price drops too low too quickly and you'll see an increase going the other direction. You can consider the RSI extremely overbought when it has a value above 80.
Let's take a look at a few ways you can identify overbought stocks, including using Bollinger Bands, the stochastic oscillator, the price-to-earnings (P/E) ratio, Fibonacci retracement levels and Moving Average Convergence/Divergence (MACD) oscillator:
- Bollinger Bands: Bollinger Bands are a popular trading tool that define upper and lower price range levels. They're used in pairs (both upper and lower bands) relative to a moving average.
- The stochastic oscillator: The stochastic oscillator, also called the scholastic indicator, is a popular technical analysis tool that shows momentum. It compares the security of a closing price to a range of prices over a certain time period. The stochastic oscillator measures from zero to 100 in bands.
- The price-to-earnings (P/E) ratio: The P/E ratio shows how much a company is worth. You can calculate it by checking into the stock price divided by the company's earnings per share over a period of time, such as the past 12 months.
- Fibonacci retracement levels: Fibonacci retracement levels take an extreme high and low on a stock chart and divide the distance between the two using certain Fibonacci ratios (23.6%, 38.2%, 50%, 61.8% and 100%). Horizontal lines on a chart indicate potential areas of support and resistance.
- Moving Average Convergence/Divergence (MACD) oscillator: The MACD shows how two exponential moving averages (EMAs) are related, particularly the 26-day moving average and the 12-day moving average. As a trader, you subtract the longer average from the shorter average to show the trend of the price action for the underlying security as well as the buying and selling momentum. Traders can look for signal line crossovers, centerline crossovers and divergences between the MACD line to understand when to buy and when to sell.
Ultimately, a stochastic value of 80 or above indicates an extremely overbought stock, while values of 20 or lower indicate that a stock is oversold. If you're debating whether or not to take action on a stock, it's a good idea to take a look at all these indicators to find out whether a stock is overbought.
Are Overbought Stocks a Good Investment?
An overbought stock doesn't trade at its true worth. Instead, it's trading over what it should. When a stock price rises too far (at a pace that is too fast and starts to look expensive to just about any trader) it is considered overbought. However, this means that the stock is doing something right in order to grab this much attention.
Good news can trigger buying interest through resistance which means that it will trigger an upswing in the stock. However, if news has been anticipated, the release could trigger profit taking. Ultimately, it's important to remember that the stock may not necessarily decline.
Traders should look for RSI values around 30 or which fall below that level, which indicates a level that is undervalued. It may be hard to get your head wrapped around a high RSI (strong short term momentum) because they are rising and may seem overpriced — you likely want completely undervalued stocks, right? However, a high RSI indicates that investors have continued to buy and that the rise will continue going up.
Top Overbought Stocks List
Let's take a look at a couple of overbought stocks as examples to help you decide whether certain overbought stocks deserve a spot in your portfolio.
Natural Resource Partners L.P. (NYSE: NRP)
Natural Resource Partners L.P., headquartered in Houston, owns, manages and leases mineral properties in the United States through its two segments, Mineral Rights and Soda Ash. The company owns interests in the following:
- Coal (the company's coal reserves are located in Appalachia, the Illinois Basin and the Northern Powder River Basin)
- Soda ash (the company's soda ash refinery is located in the Green River Basin, Wyoming)
- Trona ore (the company's trona ore mining operation is located in the Green River Basin, Wyoming)
- Other natural resources
The company's oil and gas properties are located in Louisiana while timber assets are located in West Virginia. The company leases a portion of its reserves in exchange for royalty payments. Plus, it owns and leases transportation and processing infrastructure related to coal properties.
TravelCenters of America Inc. (NASDAQ: TA)
TravelCenters of America Inc. operates travel centers, truck service facilities, and restaurants in the United States and Canada. TravelCenters of America Inc. offers the following products and services:
Diesel fuel and gasoline as well as non fuel products and services — these non fuel products and services include truck repair and maintenance services, diesel exhaust fluids, full service restaurants, quick service restaurants as well as other customer amenities.
It has several full and quick service restaurants, such as:
- Iron Skillet
- Country Pride
- Black Bear Diner
- Bob Evans
- Popeye's Chicken & Biscuits
- Burger King
- Taco Bell
- Pizza Hut
- Dunkin' Donuts
- Starbucks Coffee
The company's travel stores also offer general merchandise such as the following:
- Oil and additives
- Hardware and tools
- Cab and bunk supplies
- Convenience products (cold beverages, candy, salty snacks, sweet treats, grocery items, meal solutions, pet supplies, health and beauty products, fresh food, pre-packaged meal solutions, snacks, freshly brewed coffee, cold fountain drinks and gifts and regional souvenirs)
The company operated 276 travel centers under the TravelCenters of America, TA, TA Express, Petro Stopping Centers and Petro brand names in 44 states as well as in the province of Ontario, Canada. It also has three truck service facilities operated under the TA Truck Service brand name and one restaurant. It serves trucking fleets and its drivers, independent truck drivers, highway and local motorists and casual diners.
How to Invest in Overbought Stocks
If you think you might want to invest in overbought stocks, what is the correct approach? Let's take a look at how to analyze, open a brokerage account and buy shares.
Step 1: Identify trends and patterns.
As already mentioned, you can use a wide variety of trading tips to identify overbought stocks. You can use the stochastic oscillator to take a look at recent price movements and learn about a stock’s momentum and pricing trend. The stochastic oscillator laid the yellow brick road for the RSI, which you can figure using this formula:
RSI = 100−100/(1+RS)RSI = 100−100/(1+RS)
In all of your calculations, do you see a high RSI (above 70)? If so, it immediately tells you that a stock is overbought and it can also help you anticipate market corrections in the stock in the short term. You may also prefer to use Bollinger Bands against the RSI.
Are you identifying a stock with a high RSI and a price that goes toward the high end of an upper Bollinger Band? You can consider that particular stock to be overbought.
Step 2: Open a trading account.
Do you have a trading account? If you don't already have a trading account, choose the right option for you and fund your account. Take a look at the fees involved, the platform that the robo-advisor uses (if you choose to go that route) and other things that you believe you need in order to successfully invest.
Step 3: Start trading.
Once you've set up your trading account, consider using paper trading before you start officially trading. Paper trading allows you to practice using a fake account with fake money. If you've never traded before, you may want to spend a chunk of time learning how to trade on a paper trading account before you officially get started.
Once you're ready to start trading, choose the right stocks that you believe will meet your goals based on the RSI, Bollinger Bands, the stochastic oscillator, the price-to-earnings (P/E) ratio, Fibonacci retracement levels and Moving Average Convergence/Divergence (MACD) oscillator — whatever you choose to use. Also think long and hard about how much money you can afford to lose when trading. Never trade more than you can afford to lose on a one-time or regular basis. Knowing the risks of trading ahead of time can help you reach your full trading potential.