How Do We Play Overextended Conditions?

Oct 10, 2007: 8:50 PM CST

Many market participants, as well as many oscillating indicators, are calling the recent market action “overextended.”

By definition, price is overextended, but does this always imply a price correction because price is overextended?

Absolutely not.

What does overextension mean?

By definition, a price overextension is evidence of extremely strong and sustained buying or selling pressure, and an immense imbalance in short-term supply and demand.

While many traders are tempted to ‘fade’ market strength and try to enter new short positions against the imbalance, essentially ‘betting’ that the imbalance will resolve itself, doing so generally is not the wisest course of action.

For starters, what is your ‘entry’ signal? Where exactly do you enter a position against an overextended price move? Is there a specific set-up you look for? How do you define overextension?

Instead of trying to ‘fade’ a move, why not trade in the direction of the strong momentum?

One simple technique involves identifying the number of closes on one side of a 5-period moving average as a gauge of strength of recent price action.

In addition to using the 5-period moving average filter as a ‘trend’ indicator (multiple closes on one side indicates a strong trend), the average can serve as a place to set your trailing profit stop, so that you stay in the trade longer than you normally would have, but don’t give up too much in the ‘impending’ retracement or reversal.

Let’s look at a few recent examples:

If we expect a trend condition, we can use this filter as a point of confirmation that we should remain in a trade (or at least not enter a short-trade if we’re out).

Look at the number of CLOSES (closing prices) on one side of the MA (blue line). Stay in your trade – even though various indicators ‘tell’ you to exit – until you see one or two conclusive closes beneath the short-term moving average.

Although Apple is currently ‘overextended,’ price has not closed beneath this line just yet.

Let’s look at another popular example:

Google (GOOG):

Just like Apple, we’ve not breached the 5-period MA.

Summary:

Simply because price is overextended does not mean that you should exit a profitable trade without a plan. If price hit your profit target, by all means take some of the position off the table.

Also, you shouldn’t consider shorting such a strong momentum move caused by a sustained supply/demand imbalance.

When you’re in a winning trade, press your ‘luck’ and attempt to ride the trade for as much as it can give you. Sometimes, all it takes is a few of these trades to make your year.

However, if you exited a position with this much potential early, you will be leaving too much on the table…

and if you attempt to fight (or fade) such a strong move, you could literally wipe out your account, or at least a large portion of it very quickly.

Stay safe.

6 Comments

6 Responses to “How Do We Play Overextended Conditions?”

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