Using Overbought Signals

Many traders use RSI to measure overbought and oversold conditions. The textbook says that a reading above 70 is typically considered overbought, a reading below 30 is considered oversold. Different traders use RSI in a different manner.  Some sell a long position that has been in a long-term downtrend when it becomes overbought on shorter time frame. Some buy stocks in a long-term uptrend when they become oversold on a shorter time frame. Some only buy when a stock suddenly becomes overbought – usually after a high-volume gap, and then sell when it stops being overbought.

Here’s Greg Harmon’s take on the subject:

Perhaps there is a better way to understand and interpret the overbought condition. It may be easier if you let go of the label all together, since it is randomly selected anyway. What if instead you looked at just two things to determine if a stock is for you or not. First, is the RSI rising, falling or flat. If it is rising or flat then the momentum is increasing or holding by definition. This is not a time to avoid a stock.

Second, is the price confirming or diverging with what you see in the RSI? Price and its direction is always more important that any indicator. That is because price is all that matters to your transaction when you buy or sell. I do not like to buy stocks when they are falling. That is my rule and it is not for everyone, nor the only way to make money.

In “The Next Apple”,  I wrote about using weekly RSI above 80 as a means for partial profit taking:

The technical term “overbought” basically means acceleration in buying to levels that might not be sustainable for too long. What could possibly be wrong about an overwhelming number of buyers? It might be an indication that there is no one left to buy. Some institutions need the liquidity that new highs provide in order to exit a big position.

Using a weekly RSI above 80 is a good rule of thumb, but it is not perfect. There are stocks that remain overbought for a very long time and go up 100% – 200% after hitting that level. It is rare, but it happens. In 2013, Tesla Motors went from $ 55 to $ 200 while its weekly RSI stayed above 80. The hottest stocks of each year often don’t care about overbought conditions.

Under overbought conditions, you need to look at everything in context. Those conditions could resolve through time consolidation or through a price pullback:

– Is it a fresh breakout from a humongous base? Have earnings just accelerated? In this case, an overbought condition is likely to be the beginning of a powerful new trend, not the end.

–  Is the stock already up more than 800% in the past three years? Do most analysts have a buy rating on the stock? Is the institutional ownership above 90%? Are the CEO and the company featured on the first page of magazines, newspapers, websites? In this case, a severely overbought condition is a good reason for partial profit-taking.