What Happens When A Stock Is Overbought? Historical Analysis
When a stock is overbought, we can expect weaker returns than average over the next few days. But in the long term, returns gravitate toward the average returns. Thus, overbought stock markets only predict short-term results – not long-term.
This article tries to answer what happens when stocks and stock markets are overbought. Overbought means that markets have risen over a certain period and this might indicate weaker returns ahead. Overbought describes a condition where a security’s price exceeds its fair value, often due to recent bullish activity. The media might throw more fuel into the mix by writing positive articles and thus create FOMO (fear of missing out). Opposite, when there is “blood in the streets,” the media writes about how bad it is and creates panic.
Understanding overbought is important in technical analysis, as momentum indicators like RSI and Williams %R help identify overbought conditions. These signals can indicate potential reversals or entry and exit points, especially during strong market rallies or trend reversals.
Crowd behavior will typically drive prices to extremes, and stocks and other securities can stay there for months if the trend and story are strong.
First, let us describe what mean-reversion in in stocks is because it’s an important topic to understand the relationship between stocks and bonds:
Overbought stocks can remain in that condition for extended periods during strong market trends, and traders should avoid treating overbought and oversold signals as guaranteed reversal indicators, as these conditions can persist longer than expected.
What is mean-reversion?
Mean reversion is another description of the statistical term called regression to the mean. Both terms simply mean that strong deviations from the trend are most likely situations that later turn around and go in the opposite direction. As our backtest below indicates, you can at least expect weaker results in the coming days after reaching an overbought condition. By weaker, we mean both compared to the earlier period and the long-term average returns.
However, all rules have exceptions. We are only using statistics and general conclusions – the law of large numbers. Interpreting overbought and oversold signals is more reliable when considered in the context of longer term trends.
Remember, past performance does not guarantee future results, especially when relying on historical data for trading decisions.
What does overbought mean?
Overbought means that the stock market has risen over a certain defined period of days, weeks, or months. You can, of course, define the period yourself. Overbought and oversold conditions are key technical signals that indicate potential market reversals, helping traders identify when prices may be due for a change in direction.
If you use a daily time frame in trading of fifteen days, you need to define how much it should rise during this period to label it as overbought.
We prefer to use numbers to illustrate our arguments. Let’s formulate a trading strategy to define overbought. We use an for that purpose:
A high RSI (above 70) is commonly used to identify overbought readings, which may signal a potential correction. Traders often use other indicators, such as Bollinger Bands and the stochastic oscillator, to confirm overbought readings and improve the reliability of their analysis. The stochastic oscillator generates overbought signals above 80 and oversold signals below 20.
We show what happens when stock markets are overbought like we always do: we backtest!
Our backtest has the following rules:
Trading Rule – Overbought
- We buy at the close when the 2-day RSI is above 95.
- We sell at the close after N days.
This is a simple strategy, but we make it simple to prove our point. The Relative Strength Indicator (RSI)is used because it goes from oversold to overbought conditions constantly and it measures the velocity of those moves. When values are high, it indicates a euphoric market as it has risen a lot over the defined lookback period.
We sell after N days to show how the edge disappears after some time. We use the optimization function in Amibroker to produce this table:
What Happens When Stock Markets Are Overbought
The first column shows when we exit: row one is after 1 day, row after 2 days, etc.
The table shows that the returns in the first five days after entry are significantly lower than the long-term average, which is about 0.05% per day, please see our article about night trading to study this more. However, as time goes on, the returns gravitate toward the long-term averages – as expected.
The backtest also illustrates why short-selling is difficult: even though the results show negative returns over the first days after reaching an overbought condition, it’s not a tradeable trading strategy. Entering short positions based solely on overbought signals can be high risk, especially in strong trends. Experienced traders emphasize risk management and often combine overbought readings with resistance levels to identify potential short entry points. Successful traders also tend to scale into long positions or short positions gradually, rather than committing all capital at once, to manage risk while capturing potential reversals.
What happens to a stock when it’s overbought
Technical Indicators for Overbought Markets
Technical indicators are essential tools for traders seeking to identify overbought markets and anticipate potential reversals. The Relative Strength Index (RSI) is one of the most widely used indicators for this purpose. The RSI measures the magnitude of recent price changes to evaluate whether a stock is considered overbought or oversold. Typically, an RSI reading above 70 signals overbought conditions, suggesting that the stock price may have risen too quickly and could be due for a pullback. Conversely, an RSI below 30 indicates oversold conditions.
Another popular technical indicator is the Stochastic Oscillator, which compares a stock’s most recent closing price to its price range over a specified period. Readings above 80 are considered overbought, while readings below 20 are considered oversold. This indicator helps traders spot momentum shifts and potential turning points in the market.
Bollinger Bands are also frequently used to identify overbought markets. When a stock price touches or exceeds the upper band, it may be considered overbought, signaling that buying pressure could be reaching an extreme. By monitoring these technical indicators—RSI, Stochastic Oscillator, and Bollinger Bands—traders can better assess overbought conditions and make more informed trading decisions based on the most recent closing price and prevailing market signals.
Case Studies of Overbought Markets
Real-world examples highlight the effectiveness of using technical indicators to identify overbought markets. For instance, in 2020, Tesla Inc.’s stock price soared to new highs, with its RSI climbing above 80—well into overbought territory. This overbought reading was quickly followed by a notable correction in the stock price, illustrating how overbought conditions can precede downward pressure.
Similarly, in 2018, Amazon Inc. experienced a surge in its stock price, pushing its RSI above 70 and signaling overbought conditions. Shortly after reaching this level, Amazon’s stock price underwent a pullback, reinforcing the value of monitoring technical indicators like RSI to anticipate potential reversals in overbought markets.
These case studies demonstrate that while overbought signals do not guarantee an imminent reversal, they can serve as early warnings for traders to reassess their positions and manage risk more effectively.
Avoiding Common Mistakes in Overbought or Oversold Markets
Many traders fall into common traps when navigating overbought or oversold markets. One frequent mistake is assuming that an overbought market will immediately reverse, prompting premature sell signals. However, overbought markets can remain overbought for extended periods, especially during strong trends. Ignoring the prevailing trend and relying solely on overbought or oversold readings can lead to missed opportunities or unnecessary losses.
Another pitfall is failing to consider the trend context. Overbought and oversold signals tend to be more reliable in range bound markets, where prices oscillate within a defined range, than in markets experiencing strong, sustained trends.
To avoid these mistakes, traders should use multiple indicators and always assess the broader market environment before making decisions. By understanding the limitations of overbought and oversold signals and incorporating trend context, traders can improve their strategies and reduce risk.
Combining Analysis for Informed Decisions
To make the most informed trading decisions, it’s crucial to combine technical analysis with fundamental analysis. Technical indicators such as the RSI, Stochastic Oscillator, and Bollinger Bands can help traders identify overbought or oversold conditions and spot potential entry or exit points. However, integrating fundamental analysis, such as evaluating a company’s financial health, earnings growth, and future performance, provides a deeper understanding of whether a stock’s price is justified.
By using both technical and fundamental analysis, traders can gain a more comprehensive view of the market. Additionally, combining multiple technical indicators can strengthen trading signals and reduce the likelihood of false positives. This holistic approach allows traders to better manage risk, adapt to changing market conditions, and make more confident decisions in overbought or oversold markets.
Conclusion – What happens when stock markets are overbought?
The backtest in this article shows exactly what happens when stock markets are overbought: we can expect lower returns than the averages in the short term.
How is Overbought Defined in Trading?
Overbought in the stock market refers to a situation where prices have risen significantly over a defined period, indicating a potential weakening of returns in the short term. A stock is overbought when its price has risen above its fair value, often due to excessive demand or speculation. Overbought conditions can be defined using indicators like the Relative Strength Index (RSI). For example, in the article, overbought is identified when the 2-day RSI is above 95.
Overbought stocks can also be identified using technical indicators such as Bollinger Bands and fundamental metrics like the price-to-earnings (P/E) ratio. Fundamental analysis helps assess whether a company’s share price or a company’s stock is overvalued relative to its intrinsic value by comparing valuation metrics such as the P/E ratio to historical or industry benchmarks.
What is Mean-Reversion in the Stock Market?
Mean-reversion is a concept rooted in statistical analysis that suggests that over time, prices and financial metrics have a tendency to revert to their historical average or mean. This phenomenon is observed in various aspects of the financial markets. Mean-reversion, or regression to the mean, is a statistical concept suggesting that strong deviations from a trend are likely to reverse and move in the opposite direction over time.
When price makes a new high but momentum indicators like RSI or stochastic form a lower high, this momentum divergence can signal a potential trend reversal. Many traders look for momentum divergence at extreme levels of RSI and stochastic as a sign that the prevailing trend may be coming to an end.
How Does Media Influence Overbought Conditions?
Overbought conditions primarily predict short-term results, not long-term weakness. The media can amplify overbought conditions by publishing positive articles, creating FOMO (fear of missing out) among investors. Conversely, during market downturns, negative articles may contribute to panic.
Is overbought bullish or bearish?
Overbought is bearish in the context of trading. In an uptrend, however, overbought signals may be less reliable, as strong buying momentum can persist; in contrast, during a downtrend, oversold levels can signal potential reversals or short-term pullbacks.
It suggests that an asset’s price has risen too high, too quickly, potentially indicating an impending price correction or reversal. Oversold levels are typically identified using momentum indicators, such as Williams %R, and can indicate a short-term reversal or pullback, especially when combined with trend confirmation. Traders often see overbought conditions as a signal to sell, expecting a downward price movement as the market corrects itself.
What does overbought and oversold mean?
Overbought and oversold mean conditions in the financial markets where the price of an asset has moved significantly above its perceived value (overbought) or below its perceived value (oversold). Technical traders use indicators like the Relative Strength Index (RSI) and the stochastic oscillator to identify overbought and oversold conditions.
Oversold RSI conditions occur when the RSI drops below 30, which can signal a potential buy opportunity as the market may rebound. Conversely, overbought RSI conditions above 70 can indicate a possible consolidation or correction.
The stochastic oscillator compares the most recent closing price to its price range over a set number of trading periods, typically 14, and readings above 80 indicate overbought conditions. It is plotted as two lines, %K and %D, which signal potential reversals or trend changes. Resistance levels are often used in conjunction with overbought readings to identify potential reversal points or short entry opportunities.
Additionally, the Average Directional Index (ADX) measures a trend’s strength, with readings above 25 suggesting a strong trend. Traders often use the RSI and stochastic indicators alongside the ADX to identify potential turning points in the market. These conditions often indicate potential reversal points in the asset’s price trend, prompting traders to adjust their positions.
