What are the best ways to measure if a stock is overbought?

Determining whether a stock is overbought can be an important aspect in determining a potential trend reversal. There are a number of indicators that can be used to signal overbought conditions, although some are more popular than others. The most common indicator used is relative strength index (RSI). This interval-bound oscillator varies from 0 to 100 and is used to measure the trend moment.

RSI, which is a relatively simple metric to interpret was developed by J. Welles Wilder Jr. RSI is calculated based on the average gains compared to losses over a certain number of trading sessions, so that average gains increase relative to average losses, the RSI goes towards its maximum value. If a particular stock has an RSI of 100, this means that the price has been constantly closed higher during each individual session used in the calculation.

As the RSI becomes increasingly accurate as the number of data points used increases, would many RSI on 100 mean that prices have risen every day in 200 days in a row or more. Such extremities are very rare, the longer a stock price maintains an overbought RSI of 80 or more, the more likely it is that the current trend will be exhausted and that a bearish transformation will be broken.

Stochastics

Stochastics, or the stochastic indicator is another popular area-based measurement used to identify overbought ratios based on the ratio of closing price to price range over a given period.

However, not all indicators used to measure overbought conditions are interval bound. Commodity Chanel Index (CCI) can also be used to measure trends, and while it generally oscillates between -100 and +100 this range is not absolute.

In fact, readings that are far beyond this range are what really signal overbought or oversold conditions. CCI jämför dagens prisnivå med den genomsnittliga nivån under en viss tidsperiod. Ju mer CCI överstiger detta intervall desto starkare är den potentiella signalen. Men eftersom CCI inte är intervallbunden bestäms det att den överliggande tröskeln fastställs av volatiliteten för den underliggande aktien samt den enskilda investerarens riskhanteringspraxis.