How To Handle an Overbought Stock

One of the things we have learned in our half-decade in financial publishing is that professionals on Wall Street regularly use many terms that are not particularly well explained or even understood. Even by those professionals! 

A couple of these terms are the ideas of "overbought" and "oversold."  You have likely heard these terms often, especially recently. But what do they mean? 

The concept behind these terms is that a stock has been going up so much (bought) or down so much (sold) that the move in the stock is overdone. Meaning it is likely to stop or reverse. 

If this assumption is correct, understanding overbought and oversold can be a powerful investing tool. 

Our long-time readers know that our strongest trading signal is based on the concept of overbought/oversold. That signal is the "relative strength index" or "RSI." 

We discussed this indicator in one of our first notes here at HX Research, click here to view.

At its simplest, RSI measures velocity, which is how fast a stock moves (in either direction) in a very short time. 

In our TRADING strategies – HX Trader and HX Income – we use a low RSI and a recovery in that signal (around a 30 RSI) to screen for ideas. That strategy has an outstanding track record and speaks to the power of RSI as an "oversold" signal. 

How about "overbought" signals? Are they as powerful? 

This is particularly timely as we see many highly overbought signals and high RSIs in giant companies. 

Check out the chart of NVIDIA Corporation (NASDAQ: NVDA) with the RSI… 

You can see at the bottom with the "red" area where the RSI has traded above 70 recently for an extended period. 

Look at the stock chart; you can also see that going above an RSI of 70 was NOT a sell signal for NVDA. The stock first went through the 70 level in early January; if you sold, you missed out on another +80% move in the stock. 

How, then, do you use this signal? 

First, acknowledge that a high RSI and a stock being overbought is a much more complicated signal than a low RSI. 

Second, it is crucial to understand the context of the overbought situation. 

If a stock goes up because of significant news, you will often want to BUY it after it gets overbought.   

The most straightforward example is a positive test result for a new drug. The new drug may completely change the company's earnings profile, and the stock is cheaper than before, even if it is up a ton already! 

Something like this happened with NVDA. They reported blowout earnings, and analysts' estimates for earnings increased substantially.   

Here is that chart… 

Back in June, when the stock first got very overbought, it was as the earnings estimates began to climb tremendously. 

We discussed this in our NVDA notes a few weeks ago. 

https://daily.hxresearch.net/p/what-to-make-of-nvidia 

https://daily.hxresearch.net/p/deja-vu-all-over-again 

When you have a high RSI and a large increase in earnings estimates, you almost always want to buy the stock, especially in the intermediate term. 

One interesting aspect of NVDA's 2023 chart is that the stock broke $400 immediately but was still trading at that level six months later in October. 

Although it would eventually move higher, it trod water for an extended period before moving much higher. 

It is also important to remember that NVDA continued to see massive earnings revisions afterward. Earnings estimates went up another +80%, and the stock did nothing for those six months. 

The high RSI will often set a near-term high for the stock. We think something similar is happening right now with NVDA. 

Not that it can't or won't go higher, but that the stock inevitably takes a break. 

We believe it prudent to take some profits or at least not buy more, especially once you move through the original overbought position and are in overbought territory for multiple weeks or months. 

Do you have any stocks that are very overbought at the moment? How are you trading them? Tell us more in the comments section online (scroll to bottom of post).

What about the situation where you do NOT see the same significant positive earnings revisions and the stock is overbought? 

Here is a chart of one of our favorite companies – nuclear power producer Constellation Energy (NYSE: CEG) 

This company owns the largest group of nuclear assets in the country. It is an excellent company in a sector we love. 

Some positive earnings revisions have also been seen. Here is that chart… 

Since October, earnings estimates have increased from $5.60 to almost $7.00 or +20%. 

At its recent high, though, the stock was up almost +80%! 

This is an example where context is important. 

CEG is a fantastic company with a bright earnings future but does NOT have the earnings future of NVDA. It is also still a utility company with more traditional shareholders. 

We think CEG could eventually go much higher and set new highs. Still, in the context of everything else, the extreme overbought signal means taking profits makes a ton of sense. 

Learning how to read these overbought signals can help your risk management and save you much investing pain in the future. 

Check out Enrique Abeyta’s conversation with Carol Roth on the HX Podcast.