The term “overbought” is used to describe a market that has advanced to a point at which, historically, it has tended to reverse and move lower. Overbought is the opposite of oversold.
To identify overbought conditions in markets, traders and investors use technical indicators known as oscillators. One of the more popular oscillators for identifying overbought conditions is the Relative Strength Index.
There are two ways that identifying overbought conditions can be helpful for traders and investors. Identifying short term overbought extremes in markets that are in uptrends can help alert traders and investors to opportunities to take profits or reduce exposure.
Conversely, identifying short term overbought extremes in markets that are in longer term downtrends can help traders looking for markets to sell short.
Below is an example of a market that has become overbought. The indicator used in the chart is the 2-period RSI.
Note how two bouts of trading in overbought territory led to sell-offs or pullbacks in the overall uptrend of the PowerShares QQQQ in the fall of 2010.
As with oversold markets, the more overbought a market becomes, the more powerful the subsequent sell-off is likely to be. This is one reason why market sell-offs after extended advances can be far stronger than many expect, leading some to believe a change in trend has occurred – such as a shift from a bull market to a bear market – when in fact the market may have simply been correcting an exceptionally overbought condition.
Read more about identifying oversold conditions in How Markets Really Work: Quantitative Guide to Stock Market Behavior (Bloomberg Financial), by Larry Connors, founder and chairman of TradingMarkets and The Connors Group.