This is how I define an over-extended stock
Also check out the Yellow dot Over-extended indicator inside
"Trading is a personal journey. & therefore no 2 traders will be the same" ~ Homma
In this article, I am going to talk about:
What is an over-extended stock?
How can we define over-extendedness?
What’s over-extended for me (and some other peak traders)?
Why identify an over-extended stock? Sell into strength.
The yellow dot indicator.
PS: before reading this, please google these terms if you don’t know them already: ATR, high Beta stocks, volatility.
Also, watch this video explainer at the end of the article for more details.
Less go now.
What is an over-extended stock?
Stocks move in cycles. They go through 4 distinct stages, viz:
Accumulation or Stage 1 Base
Mark up or the Stage 2 Uptrend
Distribution or the Stage 3 Base
Markdown or the Stage 4 downtrend
When the stock is in the trending phases, 2 & 4, it tends to move in a staircase pattern—making higher highs and higher lows (and lower highs and lower lows).
This is an ideal case scenario where the Price pattern moves inside an ascending channel (AC).
While moving up inside the AC, the price cannot go on higher forever. The further high it goes, the probability of a pullback increases proportionately. At some point, the price reverts to the mean (average = the SMA/EMA of price) and this price action (extension and reverting to the mean) repeats.
The price extension at which the probability of a pullback is very high is when we call the stock over-extended.
How do you define over-extendedness?
To define over-extendedness, you must first quantify extension.
The most common way is to measure the stock price (usually closing but one can also use the high/low) distance away from its moving average.
The common moving averages that are used are the usual suspects as below:
9ema/10sma
20sma/21ema
50sma
200 ema/sma
let’s measure how extended is LICI from these MAs right now.
It is ~13, 15, 30, and, 64% extended from its key MAs.
Here comes the trick question.
How do you know if this is under-extended and could get extended further, or if it is extended significantly more than what LICI does on average?
The answer is not a constant.
It varies from stock to stock.
For example, a high Beta stock (generally the small and midcaps) can be extended 10% from 50sma and that would be normal, whereas a low Beta stock (generally most large caps) extended by the same degree might be a sign that it will retrace back to its mean.
Over-extendedness for the same stock can be different in different market conditions.
But how?
because the swings are higher in trending (bullish or bearish) conditions than in a sideways market.
Also, since “distance away from its moving average (in %)” can have a huge spread and is an arbitrary number. It is better to express this “distance away from its moving average (in %)” as a multiple of its ATR.
Example:
Stock A: ATR = 2%
Extension = 20% from 20sma
Better way = 20/2 = 10X-ATR extended.
Low Beta stocks (low volatility stocks) will mean revert from a low multiple extension, while, high Beta stocks do so after a higher multiple extension.
“BUT BRO,
You still haven’t told me, how much is high and how much is low.”
I haven’t.
But read on.
What’s over-extended for Homma?
For the kind of stocks I trade,
Microcaps and smallcaps (high Beta stocks, high ATR), this is what I consider over-extended (from observation and my experiential learning only):
close price extended more than 6X ATR(14) from 20sma.
see Alberta Davies extended in the image below:
Once this condition is met, a yellow dot appears on top of the candle.
How cool! right?
I have to say though, my condition is stringent. One can relax it to 5-6X.
What’s over-extended for these super traders?
Dan Zanger: 20% from 200sma (daily).
Rai from Traderlion: 10% from 8ema (daily).
Suresh Garu (Twitter): 100% from 40ema (weekly).
Jeff Sun (twitter): 6X ATR(14) from the 50ema (daily).
Oliver Kell: 140% above 200 sma (daily).
Why identify an over-extended stock?
Sell into strength.
There are 2 broad systems when it comes to selling.
Selling a stock when it gets over-extended. This is called “selling into strength”.
Selling a stock that is breaking down from a base or reversing an uptrend. This is called “selling into weakness”.
If your system follows the former, identifying over-extended with a higher accuracy becomes paramount for super performance. It will also help you with your FONL.
FONL? Fear of Notional Loss.
learned this from a fellow trader in my private community. Peak.
I knew the feeling, but didn’t know the word.
The Homma Extended Indicator:
Lastly,
Once you define your over-extendedness, you don’t have to measure it every time.
I have an indicator for you.
This will automatically draw a yellow dot on top of the price candle of your overextended stock.
And it will be “just looking like a wow”.
Watch this short video for a quick recap of what you learned today.
That's all for today.
before signing off, I want to reiterate that trading is a universal but personal process.
Everyone is unique; therefore, no two traders will have the same system.
One has to know oneself as a trader first. This includes answering the following questions:
what is my optimal timeframe to trade?
what is my risk tolerance?
what is the setup that I trade the best?
phalana dhimkana….
If you are unsure about your style and system, Sakatas Homma helps you find it methodically.
I do that in 2 ways:
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Sakatas “yellow dotted” Homma.
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Bro this information is killer....grt work and Thanks