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