Price overextension: misconceptions and common mistakesPrice overextension remains a widely misunderstood concept in trading, causing both novice and seasoned traders to make errors in their decision-making. This misinterpretation often leads to placing trades in the wrong direction or, equally detrimental, overlooking profitable opportunities.
In essence, price overextension signifies that the market has undergone a rapid and excessive movement in one direction. Such movements are often perceived as unsustainable. Numerous indicators, such as Stochastic, RSI, Bollinger Bands and many other, attempt to identify such "abnormal" price movements so traders could capitalize on them. Despite variations in statistical methods and calculations, their common goal is to detect instances where price went or down too much and is likely to reverse.
In this discussion, I will use Relative-Strength-Index (RSI), a popular indicator, to convey my perspective on price overextension. While some traders argue for customization, the elusive question of "how" often remains unanswered. From my experience, there are no universally perfect settings that consistently yield optimal results.
I’ll draw my examples from the recent SPY bar chart (February 2024).
The first misconception
The first misconception is that if price is overextended it is time to immediately start looking for a trade in the opposite direction. The most important phrase here is “start looking”. Many beginners misinterpret this as an invitation to commence trading, leading to the premature initiation of short positions during perceived market "overextension" and vice versa.
So, the first and foremost important advice is to never try guessing top/bottom based on one indicator or gut feeling. Simple as it seems I remember many times breaking this rule myself because the temptation was too strong. It rarely ended up well.
On the graph, I've highlighted three recent instances where the RSI exceeded 70 (indicating overbought conditions). What stands out is that, following each occurrence, the price surged significantly before consolidation set in, inflicting losses upon short traders.
Even experienced traders, who look for confluence of signals, may fall into this trap. In the first two examples, bearish candlestick patterns failed to prevent subsequent price increases. Most likely, those candles were “created” by weak hands traders, who tried to short market, while it was actually controlled by strong buyers.
These instances could have been avoided by considering the daily graph, revealing a robust bullish context – price was in an uptrend, one-time-framing up on weekly. There were couple of moments when bears gained short term control (Tuesdays 13th and 20th) but they never could take the previous week low; bulls always confirmed their control.
The second advice is to avoid trading against higher level context. While sometimes those trades might work the result is usually mediocre and most of the times you’ll simply lose. If you really wish to trade against context you need to construct a solid dossier of evidence, supporting your trade.
The second misconception
What is the second misconception? It is that when price overextended it is not time to go with the market. In this scenario, traders refrain from initiating long trades after RSI indicates overbought conditions, potentially causing them to miss profitable opportunities. It might not hurt your account but who likes missing good opportunities?
Surprisingly, seizing these trades correctly is not much harder than any other trade. It simply requires prudence and discipline and getting rid-off cognitive biases. For example, in the second example on the graph a trader could win up to 1% if he played off gap-up open after seeing that the new price has found acceptance.
Conclusion
It is possible to build a profitable strategy that relies on “price overextension” concept. However, it demands more than a cursory examination of a single indicator and adherence to textbook candle patterns. Personally, I reached a point where I entirely abandoned the use of RSI and similar tools because, instead of providing clarity, they seemed to cloud my thinking.
Opting for a more effective approach involves keenly observing actual market behavior, which often defies conventional expectations. Study of high-level contexts, understanding key levels, and discerning confluence in price action signals on lower timeframes consistently prove invaluable. This method helps steer clear of common pitfalls and contributes to enhancing overall trading results.
