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A How to Guide: Over-Extension

A How to Guide: Over-Extension

It is a widely accepted concept by market participants that price does not move in a straight line but in waves or cycles. These waves are manifested by price moving forcefully with market momentum followed by periods of calm before the momentum returns causing another sustained push forward. These periods of ‘movement’ can cause price to become over-extended from the short-term 10 and 20 period moving averages (MAs). Over-extension, although easy to spot in hindsight on a chart, is one of those technical analysis concepts that can be confusing and difficult to master.

Let’s consider an example, if we were to see over-extension on a weekly timeframe, would that mean that there is no use in looking on any of the lower timeframes for a trading opportunity in fear of a pullback in price? Or, could it mean there is a good trend in place that could offer up an opportunity for a short-term trade that would satisfy all our trading rules? I will endeavour to break down the way I use over-extension.

Let’s consider Platinum …

20160503 twp1

As you can see on the weekly chart above that the trend is up, indicators are converging to the upside and we also have over-extension (notice how far price has moved away from the 10 and 20 period MA?). So, does this mean we just scrap platinum and say “it’s gone too far, I’ve missed it” and then leave it alone? I will let you be the judge as I show the lower timeframes.

20160503 twp2

The above chart is the daily and as you can see it too is in a great trend with indicators and trend showing no sign of weakness at this stage. It is also however over-extended from its MA’s. Again, the question remains, “do I leave this product or look on a lower timeframe?”

20160503 twp3

On the 4-hour timeframe we have a strong trend, convergence with the indicators and price is no longer over-extended, as a matter of fact it is squarely in the buy zone according to my trading rules.  Now, if a trade were to setup on this timeframe, the daily and weekly charts would be in agreement in the sense that they would both be in strong uptrends with little pointing to weakness in the overall trend. Would this be a good thing? Yes, it would be!

OK, so now we know the 4-hour timeframe is in a good place with a good trend and could potentially offer a trading opportunity, but what if it doesn’t? Well in that case I would keep an eye on the daily and wait and see it there was a pull back into the buy zone on that timeframe. Yes, the daily may be over-extended now but with patience it may pull back into the zone and become a great opportunity. Over-extension may just be highlighting a fantastic trend that right now that may be a bit over cooked but with time it could become a pearl.

So that’s how I manage over-extension, to recap my approach, I either find opportunities on the lower timeframes should the higher timeframes be over-extended or I have patience and wait for the higher timeframes to come back in sync. I hope you have gained some useful insight from this blog and add it to your box of trading tools!

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