Overbought

You're cruising along the highway, windows down, tunes blasting, when all of a sudden you see a car on the shoulder with smoke billowing from the engine. That's essentially what an overbought stock looks like – it's run so hard for so long that it's at risk of overheating and breaking down.

But let's back up a sec. Overbought is a technical term that describes when a stock's price has risen too far, too fast, potentially setting it up for a pullback or correction. It doesn't mean the stock is overvalued fundamentally, but rather that it's become overextended in the short-term based on technical indicators like the Relative Strength Index (RSI).

Spotting an Overbought Stock

There are a few telltale signs that a stock might be overbought:

• The RSI, which measures the speed and magnitude of recent price changes, is above 70 (on a scale of 0-100). This suggests the stock is overbought and may be due for a breather.
• The stock's price has rapidly diverged from its moving averages, like the 50-day or 200-day. This signals an unsustainable rate of acceleration.
• Volume has surged on up days but remains tepid on down days. This can indicate a lack of committed buyers propping up the rally.

Of course, a stock can remain overbought for an extended period – think of the massive FANG/tech stock runs in recent years. But eventually, gravity has a way of pulling things back down to Earth.

What to Do with an Overbought Stock

So you've identified an overbought stock. Now what? Here are a few potential strategies:

1. Do nothing – If you own the stock and believe in its long-term prospects, you may opt to simply ride out the volatility. Overbought doesn't necessarily mean the stock will crash.
2. Take profits – If you've enjoyed a nice run, you could sell some or all of your position to lock in gains. The old adage is "buy the rumor, sell the news."
3. Use options – Consider using options strategies like covered calls or cash-secured puts to generate income while waiting for a pullback.

At the end of the day, being overbought is more of a yellow flag than a stop sign. It simply means the stock may be due for a breather after an impressive sprint higher. Prudent traders keep an eye on overbought conditions and have a game plan for managing that elevated risk.