Overbought price means a price too high, that falls shortly after. You will see an overbought market at the top of an up trend or at the top of an upward correction, in an otherwise down trend. When a stock is said to be “overbought” this means that the asset was in high demand for a certain period of time and an increased buying activity took place. A lot of investors pilled up and they pushed the price too high, because each and every next person now buys the stock from its already higher price. Every new buy order lifts the price even higher for the next buyer and at some point the market becomes “overbought”.
Its only normal for those early buyers to start taking their profit at some point. To cash out they start selling this asset. When too many investors start selling the same asset within a short period of time, they flood the market with supply. For some time supply will be more than demand, because the price was already high and no new buyers would enter the market at this time. When supply is more than demand, prices fall. Although its not necessary, but usually, after an overbought market condition is detected, the prices start falling shortly after. This can be the foundation of a profitable trading strategy, where an investors sells an overbought stock and profits as it starts dropping.
Detecting “overbought” markets is normally done with the help of technical indicators of a special type – oscillators. The chart of the indicator will oscillate between a high and a low point, showing overbought at the top and oversold at the bottom. Those indicators will not show you the direction of the trend, but only the two extremes of the prices – either oversold or overbought. Our favourite such indicators are the Relative Strength Index (RSI) , Commodity Channel Index (CCI) and Williams Percent Range (%R). In order to get clearer signals for a buy or sell order, its better if traders combine the oscillators with a trend following indicator such as Alligator, Bollinger Bands or Moving Average.
