What is Over-Extension? (or) What is Trend Over-Extension?
OVER-EXTENSION
Having explained what are the different types of trends and trend consolidation is and what criteria need to be fulfilled for each of those scenarios and how a trend changes, we can look at the concept of over-extension.
As discussed in the previous episodes, we can draw two types of trendlines.
· Downtrend line by connecting two peaks or
· An Uptrend line by connecting two valleys
· In addition to this, we can draw up or down trendlines by connecting 3 or more CPs. This is where over-extension comes into picture.
Over-extension is defined as the creation of three or more consecutive CPs in the same direction.
The CPs or pauses do not need to take any opposing zone, it just needs to have a drop — pause — drop (or) rally — pause — rally.
A drop or rally should be formed by ERC leg in & leg out candles, whereas the basing candles represents the pause in the market.
We can draw a more aggressive trendline connecting the last three CPs. Over-extension is great for counter-trend trades. The break of an aggressive TL can also create an imbalance.
Why do we have over-extension?
Market participants can get ahead of themselves a lot of times and fall into the trap of greed and fear. These irrationality is what makes prices to look overextended on the charts.
However there comes a time where simply market participants get exhausted and the buying and selling pressure eventually subsides. This is shown as a pause or a pullback on the chart.
Price will eventually revert back to the mean — a state of normality. I am sure you have been part of such an irrational move before yourself.
How often in your trading career have you found yourself desperately wanting to get out of a trade when you saw price falling like a rock?
I am sure you have realized by now, while practicing correct level drawing that peaks and valleys are frequently not there. All we have are little pauses, which reveal themselves as continuation patterns (CPs).
The issue now is, if you do not have peaks or valleys and thus are not able to draw a trend line, how can we identify what type of trend we are in?
The answer to this is to draw an aggressive trend line. The break of such a line has the same consequences than that of regular trend line. You do not have to use them as the rules above stating the break of 2 demand / supply levels already accommodate for this.
So when are we overextended and when we will be able to draw an aggressive trend line?
We consider over-extension when we clearly see that price has been moving in one direction non-stop by:
· Creating 3 or more clear CP patterns
· Visually strong up or down moves with huge candles covering a huge price distance in a very short time compared to other candles
· Price rallying indefinitely creating a series of CPs and valleys/peaks.
Note:
· We need to analyze each case in particular. When this happens it’s recommended to keep on trading in the bigger picture’s direction while applying the realignment and sequence rules.
· Once you get a loss on a clear level, you should stop trading in that direction until price realigns itself with a higher time frame demand level (uptrend), higher time frame supply level (downtrend) or you trade on confirmation.
· Confirmation trades is discussed in more details in later lessons so do not concern yourself with this aspect
· When 3–4 CPs happen in a row, over-extension may start happening and it’s very likely that price will return to the origin of the whole move to 1 HTF valley/peak or HTF bullish/bearish engulfing pattern
· Please keep in mind that there is no rule that will turn a CP into a valley/peak or vice-versa to make things easier. The structure of an imbalance can’t be changed once the structure has been created.
For more details and examples, checkout: