Overbought is a term used when analysis indicates demand seems to have been escalated by investor emotion or media hype, beyond the point where it can be sustained or supported by fundamentals. The increased demand drives the price of the security up for a short time, before the overbought security likely experiences an eventual sell-off and price decline.
It is hard to determine when a security is overbought, but the Relative Strength Index (RSI), an momentum oscillator developed by Welles Wilder, is one tool that can help make a determination. In the RSI, the average gains and average losses over a specific time period (such as 14 days) are divided to calculate the Relative Strength, then normalized into the Relative Strength Index (RSI), which is range bound between 0 and 100. The RSI typically fluctuates between values of 70 and 30, with higher numbers indicating more momentum. According to this indicator, a security with an RSI over 70 (out of 100) can be considered overbought.
The RSI indicator is often used in conjunction with moving averages and stochastics readings to formulate a trade idea. If a trader notices that the RSI has crossed over 70 (see chart), while the stochastics readings and moving average also indicate bearish conditions, the trader may consider selling the security or exploring put options.
The opposite could also apply. If the RSI indicator dips below 30 (see chart) and the stochastics and moving average indicators also show a potential bullish trend, the trader may consider taking a long position in the security or exploring call options.
Divergences between the RSI and the underlying index or security may indicate a potential reversal point. For example, if the underlying security is trending down and hits a lower low, but the RSI hits a higher low, it can be considered a bullish divergence.
Where a score of 100 would indicate no negative periods and a score of 0 would indicate no gains during any periods, the basic idea is that somewhere in the middle of all that (around 50) would be the "true" value of a security, and deviations too great are indicative of overbought or oversold conditions.
Traders use technical indicators like RSI to make predictions about future prices. They verify how well a specific indicator works for a particular security. The calculation of the odds of success under similar market conditions is the best way to go.
Technical analysis is more popular than ever, but it’s important to remember that there is no single indicator that works well for all securities. Technology allows us to not only see and share trading information more quickly than ever before, but to automate trades using a disciplined technical strategy we define. Artificial intelligence tools from Tickeron can aid traders with trade ideas, help analyze signals to execute advantageous trades, and assist investors with making rational, emotionless, and effective trading decisions.