Market overhang is a market phenomenon whereby investors hold off trading a stock that’s seen a drop in price, because the expectation is the price will drop even further.
A market or stock overhang can be precipitated by the awareness that a large block of shares — say, from an institutional investor — is about to hit the market, potentially driving a stock’s price down. But it can result from other factors as well. Although the event has not happened, investors may hesitate to sell or buy shares in anticipation of price drop — and this can further depress the stock price.
While there is also a business use of the term “overhang,” we’ll primarily focus on how market overhang works in finance and what it means for investors.
Market Overhang Definition
In its broadest use, an overhang describes a somewhat artificial market condition brought on by an anticipated shift in supply and demand (a.k.a. the price of a stock). Market overhang has a couple of uses in the business and finance worlds, and in an IPO market as well.
What Is an Overhang in Business?
An overhang in a business context can refer to the practice whereby a company, typically an industry leader, delays the release of a new product in order to stoke greater consumer demand for that product.
A familiar example might be the release of a new technology product or video game. The anticipation of the new release may cause consumers to avoid buying other products as they wait for the arrival of the new one. The overhang may result in lower purchases for existing products — and higher purchases of the newly released product. While this practice can be considered manipulative, it’s not uncommon.
What Is an Overhang in Finance?
More commonly: An overhang in finance is used to describe a dynamic that’s specific to how investors’ expectation about supply and demand can impact a company’s share price.
A market overhang is when a stock’s price declines because investors expect a further price drop on the horizon. Thus, some shareholders may hesitate to sell their shares, because that could further drive down the share price. Other investors may also hesitate to buy shares because of the anticipated price drop.
The business use of the term and the finance use describe different situations, but the common element is how investors’ anticipation of a future event can impact a company’s revenues or share price.
Needless to say, a market overhang can cast a shadow over a company’s performance, influencing share price, liquidity, and more, especially if the situation is prolonged. In many cases, though, market overhang is relatively short-lived and temporary. The difficulty for investors is knowing when the overhang, like bad weather, is finally going to pass. To that end, it helps to know some conditions that can cause a market overhang.
How Market Overhang Is Created
There are a few conditions that can lead to a market overhang. Often these conditions can overlap.
A Stock Decline
The first is where a stock is already declining, perhaps owing to a change in key economic indicators or market conditions, and there is a buildup of selling pressure as investors hesitate to let go of their shares in a down market. This type of market overhang may be resolved once there are signs of price stability (even if it’s at a lower level).
The Role of Institutional Investors
Another type of stock overhang can be created by institutional investors — or companies that manage investments on behalf of clients or members of a firm. Institutional investors tend to have a larger stake in a particular stock compared with individual investors. This means that when the institutional investor plans to sell a large portion of their shares, a market overhang could kick in when investors become aware of this possible sale.
The anticipation of a large block of shares entering the market could drive prices down, and thus investors might hold off trading this particular stock — impacting its price, even before the institutional investor has made a move.
The stock overhang might be worse if it occurs during a price decline. In that case, investors may see the decline in share price, become aware that a large investor may sell a block of shares (which could further depress the price), become even more wary of buying or selling the company’s shares.
IPOs and Market Overhang
A third way that market overhang may occur is after an initial public offering (IPO). An IPO market can be a hot market, after all, and a company may get significant press coverage as its IPO approaches, which can drive up the stock price.
But if the IPO isn’t a big hit, and the share price isn’t what investors hoped (in IPO terms), there might be a bit of an overhang as investors wait for the lock-up period to end. The lock-up period is when company insiders can sell their shares, potentially flooding the market and further lowering the price.
Understanding the Effects of Market Overhang
Market overhang can last for a few weeks or even months — sometimes longer. The chief impact of a market overhang is that it can artificially depress the price of a stock, and if the market overhang is prolonged, that can have a negative impact on company performance.
As noted above, a market overhang typically ends when a stock price stabilizes. Unfortunately that often occurs at a lower price point than before the shares began to decline.
Example of Market Overhang
While some consider the market overhang phenomenon more anecdotal than technical, it’s something to watch out for. It could present an opportunity. And it doesn’t require a complicated, technical stock analysis to understand.
For example, let’s say a large tech company is trading at $300 a share. But there are reports that the company has been facing some headwinds, and it may undergo a rebranding and repositioning. In the face of this change and uncertainty, it’s natural that it might impact company performance and the share price might wobble a bit. But then, if enough investors are concerned about the company’s “new direction,” there could be a bigger shift in trading behavior that might further depress the share price in advance of the company pivot — creating an overhang.
While this isn’t ideal for current shareholders, a market overhang like this could be a “buy” opportunity for other investors. It depends on a number of factors, and it’s always important to understand market trends as well as company fundamentals. But it’s possible that some investors may view the company as a good prospect, despite a currently undervalued share price, and buy shares with the hope they might rise to their previous levels.
Why Market Overhang Matters
Market overhang is a valuable phenomenon for investors to be aware of, largely because it reflects many of the basic tenets of behavioral finance, which is the study of how emotions can impact financial choices. A market overhang could be viewed as the result of loss aversion and herd mentality — two well-documented behavioral patterns among investors.
Loss aversion is, as it sounds, the wish to avoid incurring losses. Herd mentality is, not surprisingly, the tendency for investors to behave as a group: buying or selling in waves. You can see how these two very human impulses — to protect oneself from losses, and to follow the herd — might create a market overhang.
The good news, though, is that investors are capricious and markets can be volatile, which means the market overhang will usually pass, and the stock will regain its normal momentum, whatever that may be. As an investor witnessing the changing weather, so to say, it’s up to you whether a stock overhang might present a buy opportunity or a sell opportunity — if you need to harvest some losses, for tax purposes.
What Market Overhang Means for Shareholders
Market overhang affects different shareholders differently. Since institutional investors tend to be the ones who create market overhang, they also tend to have the upper hand on what it means for their investments.
Regular investors might worry that some of their shares are losing value. But with the ebbs and flows of the stock market, a price can rise and fall at various times throughout the year — even throughout a given day. Fluctuation is normal and this is part of the risk in investing in the stock market. Consider waiting out the storm to make an informed decision. There’s a chance the stock could rise to new highs and your investment will be worth even more.
What is a market overhang? While this type of trend is considered more behavioral in nature, it’s worthwhile for investors to keep it in mind when a stock isn’t performing as expected. In some cases, when investors anticipate an event that could drive down a stock’s price, they may hold off on trading that stock, further depressing the price and creating a market overhang.
In that sense, a market overhang can become a self-fulfilling prophecy. Institutional investors can create a market overhang, for example, when they contemplate selling a large portion of their holdings. This might spook other investors, who likewise decide not to trade their shares, creating a sort of temporary downward spiral in the share price. But because two common investor dynamics are at play here — the fear of losses, and the desire to comply with what other investors are doing — the emotions are usually temporary, and the market overhang passes. And just because a price decline might upset some investors, it could present a buying opportunity for others.
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