What Is Overbought in Trading?

Published on December 1, 2022

Fact checked by

Person looking at a computer with trading data on it — Photo:
visualspace / Getty Images

Definition

Overbought in trading means that in the opinion of the investor, the market price of a given security has increased too fast in comparison with the security's intrinsic growth fundamentals. Investors may use many key indicators to determine if a security is overbought and make investment decisions accordingly.

Key Takeaways

An overbought security is one whose price has increased faster than the underlying fundamentals.
One can determine whether a security is overbought by using fundamental and technical analysis indicators such as the Relative Strength Index (RSI), moving averages, P/E ratio, and P/S ratio.
Overbought securities may be optimal buying or selling opportunities for investors.
Investors should not rely on the indicators alone when making investment decisions.

How Overbought Works

You are likely familiar with the phrase “buy low, sell high.” It’s a timeless principle for successful investing and serves as the formula to make a profit in the market. Investors are faced with the task of determining when something is at its respective “low” or “high” price, often using fundamental and technical indicators. If, after analyzing the underlying indicators, an investor determines that a security is overbought, they might wait for a more optimal buying price or perhaps buy short positions in the security.

Some common fundamental and technical indicators investors use to help determine whether a security is overbought include:

Relative Strength Index (RSI): The RSI indicator measures the speed at which a security changes in price and is measured on a scale of 0-100. RSI above 70 may indicate the security is overbought, and an RSI score below 30 may indicate the security is oversold.
Moving averages: A moving average is a time series of means that take the prices of each time interval and divide them by the number of intervals. (A “mean” is the average of a set of numbers.) This indicator is referred to as a "moving" average because as new prices are generated, older data is dropped and replaced by the newest. If a stock is trading above the moving average for a given time interval, it may be considered overbought. For example, if the average share price of ABC Co. over the last 20 days is $95, and the current share price is $125, then the stock is currently trading above average for the last 20 days.
Price-to-earnings (P/E) ratio: The P/E ratio is the price of the stock divided by the annual earnings per share. If the P/E ratio is above the industry average, the stock may be considered overbought.

Price-to-sales (P/S) ratio: The P/S ratio is the price per share divided by the sales per share. If the P/S ratio is above the industry average, the stock also may be considered overbought.

Note

Fundamental and technical indicators do not guarantee that a security is overbought or oversold, nor do they guarantee the future direction of the security’s price. These are no more than indicators that aid investors in making investment decisions. Always talk to a financial professional before making investment decisions.

Example of Overbought

Ben, an investor, is trying to determine whether EV Motors is selling at a reasonable price or if it’s overbought. His goal is to buy EV Motors at a fair value and hold onto it for the long term. Upon analysis, Ben discovers the following about EV Motors:

RSI is currently at 75.
It’s well above its 20-day moving average.
The P/E ratio is double the industry average for electric vehicle (EV) companies.
The P/S ratio is about three times the industry average.

These indicators all suggest that EV Motors is likely in an “overbought” condition. Because Ben’s investment objective is to buy the security at a fair value and own it for the long term, he decides to wait until these indicators are out of the “overbought” territory.

Overbought vs. Oversold

Overbought	Oversold
The price of a security increases too fast compared with the underlying fundamentals	The price of a security decreases too fast compared with the underlying fundamentals
Determined by using fundamental and technical indicators such as the RSI indicator, moving averages, P/E ratio, and P/S ratio	Determined by using fundamental and technical indicators such as the RSI indicator, moving averages, P/E ratio, and P/S ratio
Poses potential opportunities for short positions	Poses potential opportunities for long positions

What It Means for Individual Investors

Understanding when a security is overbought can be a vital sign for an investor in determining whether now is the right time to buy or sell a security. Investors can easily analyze a security’s financial statements or chart patterns via sites such as Yahoo Finance or via their investment bank website to obtain the fundamental and technical indicators needed.

Investors should also be mindful that overbought indicators do not guarantee the future price movement of a security.

Frequently Asked Questions (FAQs)

How do you tell when a stock is overbought?

A stock may be considered overbought when fundamental and technical analyses indicate the price is trading higher than normal. Common indicators used include the RSI indicator, moving averages, P/E ratio, and P/S ratio.

What is the difference between an overbought and oversold stock?

An overbought stock means that the price is increasing at a rate faster than the intrinsic growth of a company, and an oversold stock means that the price is decreasing faster than the intrinsic growth of a company.

Was this page helpful?

Thanks for your feedback!

Tell us why!

Sources

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.

Fidelity. “Relative Strength Index.”
Fidelity. “Moving Average Trading Signal.”