One of the most common questions I’m asked is: “Do I sell stocks or index ETFs when they’re technically ‘overbought?’”

Now, technically, an “overbought” stock (or any tradeable instrument) has reached a point where it’s begun to get above measures that imply it’s gone up more, in relative terms, than it should have, whether that’s in a given timeframe, or price and volatility range, or any number of other factors which can be measured and a mean established. More about this in a minute.

But, I always answer folks, “No. I don’t sell anything just because it’s overbought, but I do something else that you should do, too.”

I’ll show you why I don’t sell these assets automatically, and what I do instead to keep my profits secure.

What Overbought Means (and What It Doesn’t Mean)
I gave you the textbook definition, but what does overbought mean, really? That’s the first question you should ask. And don’t beat yourself up if you don’t know the answer, because the truth is there is no absolute or even good answer. There are only parameters that matter (until you blow through them and they don’t matter).

A tradeable instrument can be overbought or oversold – those are just different sides of the same coin. The most common measure of “overbought”-ness, or “oversold”-ness is the Relative Strength Index (RSI). What you consider in terms of being overbought, or oversold, are the same metrics, levels, and stochastics reciprocally applied.

The RSI runs from 1 to 100, so the mean or midpoint is 50. So, when your stock or ETF or whatever gets to 70, it’s said to be overbought. And the higher above 70 you get, the more “overbought” you are said to be. On the downside, when your RSI level dips to 30, you’re considered oversold.

If you’re at 100, you’re in a really overbought position.

Just because you’re at 70 and rising steeply above there – as a lot of stocks are doing right now – doesn’t mean they’re ripe for selling because they’re “overbought.”

That’s because RSI, as an indicator, is itself relative.

What’s much more relevant to me than any high RSI reading is what the market’s doing. The market has been rising for a number of reasons we won’t get into here, but, if the trend remains intact and momentum is positive, then RSI can stay elevated for longer – a lot longer, in fact.

So, yes, RSI levels north of 70 indicate overbought conditions. But the conditions that brought the stock or market higher can continue, for who-knows-how-long.

That’s why I don’t sell winning long positions when they’re “overbought.”

Here’s What to Do When You Find Yourself in Overbought Territory
If you’ve been with me for a while, you’ll know walking away from a winning position – leaving money on the table – when my stock or ETF has every chance of rising higher on the strength of the market trend and momentum is the last thing I want to do.

So, when a winning position becomes overbought, I take steps to lock in profits. What I do is adjust my stop-loss orders. In this case, they’d be profit targets to capture if the stock slips backwards.

That’s how I use RSI. I keep it simple. While I like to know where my positions are in terms of indicators like RSI (if for no other reason than other traders are watching them, too, and may act on them), I use RSI as one component relative to what the trend and momentum of the overall market is.

And that’s the key takeaway here: Relative anything is… relative. Don’t live and die by overbought or oversold conditions or chatter. Rather, rely on the trend you’re riding and whether momentum remains positive or shows signs of fading.

Keep it simple and always protect your profits and you’ll do just fine.

— Shah Gilani

Source: Total Wealth