Updated: May 24, 2021
The basic premise of trading the extension is a slight return to normality in regards to price, once the price extends quickly, chances for pullback increase, but this only is the case if certain conditions are met, or if the extension itself is defined with particular variables even to measure the chances of "return to normality."
Rubber band stretching and its snap-back are often used to explain this process in price movements. Still, using such statements borrowed from physics is that can be a very over-simplified definition of extension and what traders can expect.
Certain consistent price moves in markets will snap back with retrace and some will not, meaning that they will keep extending more and more before they eventually snap back. And those differences in behavior do matter, as, in the real trading world, one cannot operate with the mindset of "eventually I will be right" since that is a sure way to get in trouble.
This is why it is helpful for a trader to separate each of the moves in markets into specific categories and define them well to avoid participating in certain moves that do not qualify as a higher probability. A common mistake that traders tend to make is that they keep recycling the same naming scheme for a different type of moves, which makes them at the end confused and often getting into trouble expecting behavior on move A to be the same as on move B, even though that those two moves are technically not the same if categorized well. And after the same naming scheme for orange and apple, it follows the same trading approach for each, which makes everything worse.
Simple differentiation for the moves personally used is:
- "pops": Small move under five candles, % of the move is non-specified. Could be on the backside of the asset could be on the market open.
- "extensions": Move of at least ten consecutive bull/bear candles with 8% or more price change in the move.
-"parabolics": Move only present on the front side of an asset, under very strong % move (30%+) with the parabolic curving of both volume and price.
This helps better to define rules and trade approaches on each move and collect the behavioral data on each of them about the context, rather than just bulking everything into the same basket.
From a practical standpoint, many traders get significant losses on trading against the moves because they do not have a clear distinction between the types of moves. They often start to add and add against the move too early where the "pop" eventually turns into "extension," and by the time extension turns into "parabolic," it is already too late and to loss is significant as a trader was not accurately distinguished the move or did not have clear risk control differences of how to approach each of those moves with a different method of entry scaling and loss cutting.
Thus the "extension" move will be outlined in this article as a specific move set by the specific rules that are different from just any other "strong" move itself. Examples noted in the article are for all markets, as they can be applied across any instrument, but not necessarily will all instruments create equal opportunities. For example, quicker moving assets with strong volatility will create plenty of opportunities on extensions to trade, while slow-moving low volatile assets will create fewer opportunities. There is also the difference between asset classes themselves; equities will, on average, provide the most opportunities, crypto-assets following second, FX assets third, and then the rest of assets will fall into a less likely category.
Consecutive bull or bear candles
One of the essential variables of solid extension is continuous candles within the direction of the move. For example, if the extension is moving to the upside, then most candles in the move should be bullish candles (90% of them), or if the extension is moving south, then the majority of candles should be bearish. This ensures that the liquidity gap is created and the profit-taking does not occur at a large scale at the early stages of the move, but rather at later stages mostly, exposing one side of order flow at the later stage of the move.
My rule is that there should be ten consecutive candles in the move before it starts to get interesting, but this will largely depend on how quickly and strongly the price is progressing, since in certain cases if the price extends large % with fever candles, it can qualify as well.
The idea behind having several candles in the row as opposed to just having one or two candles on trading the extension is because, on more candles, the trader is better suited to determine how quickly the movement is expanding, while on single or two candle move that might be much harder as there is not enough context to fall back to. Without enough data context, it is impossible to tell the progression of the move over time, which is why ideally, there should be ten candles in the leg/move.
The difference between more ideal (left) and less ideal (right) extensions in terms of consecutive directional candles (for bullish example, same concept but vise versa applies for bearish):
The sizes of candles should lean towards larger size rather than smaller, especially within the average context of the ticker/asset trades in previous days—the stronger / larger the candles, the better.
Ten candles in a row is a good rule of thumb for the reason that in many cases, when the significant % move happens in only two candles, for example, it will be on the news catalyst, and such extensions are far less reliable on behavior as they can push much further. Thus ten candles rule often tends to filter out the catalyst initiated moves, at least in their early stages. It should be noted that extensions, as shown in the article, are not traded on the catalyst/news releases but instead in average order flow/market conditions.
Liquidity air pocket (no major pullbacks)
Speed of progression:
The conceptual example below shows the difference between a slow extended move that is grinding higher on small volatility and consistent micro pullbacks (half-sized bear candles after each second bull candle), while the right side shows very strong and quick move, that completes the same % drop move but at much fewer candles at a much quicker pace. The extensions that should be traded should follow the example on the right, not the one on the left since slow grinding moves tend to over-extend beyond very often. Such moves are not ideal to trade against in expectation of retrace.
An ideal equation to follow is the last ten candles (all bull or all bear candles) with a moving minimum of 5% (equities only, crypto needs half that), and a news event does not trigger the move. Those three are basic components of potential extension play. However, there are external variables that trader should include in the thesis to increase the probability, such as:
-the extension is a counter-trend move (against a higher time frame)
-the later part of the move in extension, the candles are on much higher volume than the initial candles at the base of the move
-the move is initiated on smaller capitalization asset (small-cap stock or alt-coin in crypto)
-the volatility of the move is far higher than the average volatility on the instrument over the past 30 days.
A grade conditions:
Connecting the right variables is essential to separate B grade opportunities from the A grade opportunities and avoid as much as possible B quality setups. But the first trader has to understand what is happening behind the A grade setups in terms of order flow to gauge realistic expectations on setups. Extensions are generally about trading liquidity pockets created after the firm and even surge/drop of price, where the order book is unable to quickly enough stack the bid or the ask to prop the price (along the direction of extension). Eventually, the counter order flow starts counter move by profit-taking and market orders. That is not always the case, but ideally, that should be a portion of the picture behind the reasoning.
A conceptual example of order book stacking/propping along the move to "bucket" potential fall or retrace. An example on the left is a slow movement where the order book has time to re-stack under price with the bid as time gives traders enough window to do so, while the example on the right is a fast move where the order book will have less time to quickly re-stack the bid making strong and quick counter more likely:
The examples above are by no means 100% guaranteed, however across a large sample base of assets there is often a significant difference in terms of order book positioning as shown above. Variables for A grade conditions as outlined in the example below:
Entry approach on extensions
Entry approach, valuable rules to follow (only suggestions):
-scale in few entries instead of just a single entry as timing the end of the extension is not that easy unless there are apparent volume anomalies present
-start with the smaller size if the price is not yet fitting. A grade play to avoid participating with strong size too quickly and getting in a situation where one cannot add to size anymore
-short into ask and long into the bid to be pre-positioned before the actual micro rejection, this increases RR slightly
-have a fixed risk level in mind, but be flexible based on price behavior and tape; avoid using hard stops on extension plays. A trader should be flexible and adjust the risk based on how the price is behaving. Tightening the risk of behavior is not ideal; expanding the risk of behavior is suited towards A grade variables.
-scale stronger position size towards the stop-out level as long as the price keeps extending quickly, this means putting one last add with a stronger size near the stop-out level; this last add will not stretch the loss much if the trade does not work out, but it will make a significant difference on a winner if price turns into traders direction at that point.
Below is an example of how trades can be scaled in on the ask for a short trade before the price reaches that level (with limit orders) to ensure being ahead of the actual micro rejection. The basic premise is that this increases the chance of liquidity micro-gap to be created as once price micro rejects and stalls for 1 or 2 minutes, bidders will have a chance to re-fill or re-position, while if the move is right into the upper area of the price it has a lesser chance of doing so.
Example of scaling position in 3 chunks, each spaced out at an approximate similar distance. However, the distances between each add should be adjusted on the live market conditions, based on how quickly the move is progressing, if the price stalls more the distance of add should be bigger, if the price is expanding fast (but not too much volume) the distance between adds can be shrunk as liquidity pocket area has higher chance to develop there.
The scaling in and cutting position is shown in the example below. It is necessary to "listen" to the price behavior to determine if cutting position or adding to it makes sense. Keep liquidity gap/pocket in mind; if the price keeps pressing solid and quick, then adding might be better, while if it starts to consolidate and keeps pushing with a new micro high, it might be a better idea to think of cutting position instead. I do not believe in the hands-off set and forget to stop the loss method in any market in any traded setup. Setting hard stops and leaving the screen is a lazy way and low-performance way to approach trading. Instead, a trader needs to research the patterns to establish what kind of behavior is ideal and what kind of behavior is less ideal, and the decision making should adjust in the middle of trade based on those conditions, depending on how price/pattern is developing. There should be robust/static rules in terms of risk control for each trader. Still, there should be as well slight adjustments and dynamics implemented into each specific trade based upon the particular behavior of the current traded example.
High volume candle climax
High volume candle at the later part of the move is ideal for extension play, as often those high-volume anomalies might be climaxes of the movement where the price reverses after-wards. The key, however, is that this volume anomaly has to be substantial, and it has to stand out from all the rest of the candles in the move. It is not just about the fact that it has the highest volume compared to the rest of the candles, but it needs to be rather significantly higher volume. Using absorption tools for order flow such as volume delta indicators is often a good idea to spot if the climax candle indeed had a large amount of counter-order flow absorption or not.
High volume anomalies primarily work in more asymmetrically traded assets that do not trade very even volume all the time. Such asymmetric assets are crypto coins, futures, or small-cap stocks.
Assets that trade much more evenly (the order book is stacked very symmetrically, and each M1 candle has a similar volume); this method will not perform well since there will not be enough clean anomalies on volume to tell where the real order flow just came in to initiate rejection. Such symmetric assets are usually higher capitalization assets, such as large-cap stocks with small volatility. Futures or FX assets fall somewhere in the middle, depending on the day and liquidity conditions.
Below is an example of an evenly traded asset in terms of volume and average liquidity (left) and a more asymmetrically traded asset (right). The right example is ideal for more frequent volume climaxes on the end of extensions(frequently present in crypto, for example):
The point being that in symmetrically traded assets climaxes will be very rare or very hard to spot. While the opposite is the case for the asymmetrically traded assets.
Examples below on Ethereum (ETHUSD) of high volume anomalies/climaxes at the end of extensions:
Another example of high volume rejection (on the smaller candle) on Ripple (XRPUSD) and decent selloff after it.
Below is an example of another extension on Ethereum with high volume rejection / pin bar candle on the latest part of the move and bottom formation soon after it.
Failed extension play (risk control)
Usually, the extensions after their first rejections where the price comes back and consolidates tend to keep moving further in the extension direction afterward. It is essential to keep this micro clue in mind for risk control on extensions. With more straightforward words, extensions that do reject tend to do it quickly. In contrast, if rejection does not come fast and the price consolidates, the chances for continuation into the direction of extension start to increase.
Knowing when extension might fail to deliver counter-rejection and might keep going is perhaps even more important than understanding how to find the extension or position in the move itself. Cutting losses on an extension that does not behave along ideal behavior can save traders a lot of unnecessary losses and mental capital and potentially spare more R towards setups that deliver strong rejections and quick profits.
For risk control on extensions, it is better to "listen" to price behavior rather than just setting hard stops ahead. This is because a trader does not know how the price will progress after the initial starting entry, and the stop-out level should also adjust based upon the behavior of the price. Hard stops are better set only once the trader is already in with the majority of position size at the 3rd level of extension. The setup itself has confirmed entry worthy or potentially A grade (even if it eventually fails).
The image below shows how ideal extension rejection should perform (left) and how less-ideal extension behavior with consolidation might start becoming a reason to consider exiting/cutting position.
Again, it should be noted that a trader must study this behavior over a large sample base of examples to build conviction behind why such risk procedures should be taken; theory in itself does not give trader enough conviction.
The example below shows extended move on relatively smaller percentage (does not qualify 5-10% move) and the base formed after initial extension. The base then is breached with a push higher. In such a case, it is better to cut the trade if the trader is short because one never knows how much further will second leg go.
The example below is an extension and failed bounce/rejection where the price breaches the initial micro bounce with fresh lows and pushes further on the second leg of extension. The time window is very important, once the first initiation of bounce is shown on rejection the price has to respond within the next 10 minutes, if it does not and it consolidates usually the second leg of the extension comes next and the micro low will break such as the case below. Extensions are about trading fast snap-back rejection, not the consolidated rejection that takes a lot of time to perform.
Study of behavioral data on winning and losing setups
Traders should always study the performance and behavior of winning and losing setups to find the common behavioral paths on each side.
In some patterns, the differences are very clear, while in others, they are not as clear, but usually, there is always some data that will be enough for a trader to lean on. One such data structure for extensions is the time window at which price has to respond with rejection.
Usually, extension setups that do work out perform relatively quickly, where the rejection delivers a 30% retrace move (against extension leg) within just a few candles.
And the setups that fail show no strong response for many minutes (10,15,20 minutes), and eventually, the consolidation is breached by a fresh second extension leg. Using this time window is very helpful to identify if a trader is more likely than not on the right side of the trade (if the trader is trading against the extended move). It should be noted that all-time examples are pointed out strictly for 1 Minute chart setups. If one were to apply this to higher time frames, the time window must be stretched/multiplied with the correct ratio.
The time window is a robust example of the kind of data that traders can use to help justify adding or exiting out of position, but by no means should it end there. It is up to the trader to dig deeper and get even more detailed data/variables to lean on, such as specific behaviors on order flow (tape, chart, volume) that perhaps signal some common clues on failed setups in which winning setups are not shared as much. Some of those clues might be very difficult to find and require many hours of in-depth studies. It is up to the trader to establish whether it is justified or not to access that data.
Establishing valuable variables in traded patterns requires experimentation with trial and error on the data, mind that the majority of free publications on the net, videos, or books will only give you very basic entry/exit "strategies," but the real data that has robust value for the actual performance of specific situations is much harder to find, as that takes real work, research and cannot just be recycled from reading something and passing it forward.
Not ideal play for beginners due to looser risk controls
The issue of trading extensions for beginner traders is that it is a trading approach against the directional move of the market, which can quickly put traders into a mindset of "fighting the market," especially if the price keeps going against the initial position of the trader. Having patience and selectivity is thus crucial on extensions because it is too easy to get in position too quickly and then stepping into the mindset of fighting the market if the price keeps extending.
Trading against the market and extended moves naturally lures beginner traders; it is something that many less-experienced traders find themselves comfortable trading with, which is surprising. One would expect that majority of beginner traders would be inclined to follow the trend of chasing methods in the market, but in fact, it is quite the opposite (especially for short-sellers); many more are much more comfortable stepping against the move and justifying it "there is no way it can go higher than this."
This kind of mind frame is very frequent. It can be devastating to operate with, especially if the trader is not selective enough or does not have enough experience to use previous bad examples to teach him how to better use risk management on such plays.
This by itself makes extensions a difficulty often for beginners unless the trader is very disciplined and understands that the actual trade is not just about trading something that "has no chance of going higher."
The critical issue comes from the fact that there are no clear boundaries of price action in extension trade to lean on with stop-loss (usually). This opens risk wide open and makes the risk approach very subjective if the trader does not have clear rules on approaching the play.
This is why there is only one cure to solve those issues, besides getting more experience in trading the setup itself: gather the data. Know what you can expect from the behavior of the patterns by collecting a large sample size and finding common attributes between losing and winning setups. This is the critical step that many do not take, and the issue outlined above becomes that much more problematic. It does not solve all issues, but it surely is the first major step to take.
Using macro trend and specific market hours to define opportunities
Often better extensions will develop in the first 45 minutes of market open for equity markets, such as the case for CODX below. The volatility and liquidity will often be at the highest levels around those hours for equity assets providing a more significant chance of extended moves in a single direction.
Ideally, the extension play is where the extension is a move against the general trend of the asset. For example, the ticker is in a macro uptrend but the extension is the move south (macro up, micro down). A conceptual example where ticker is on a macro uptrend, but extension move is south (drop), which is a more ideal case to trade such extension to the long side since it follows macro direction.
Or the opposite case where the ticker is in macro down trend and the extension is the move to the upside:
This is especially useful on assets that trade in very consistent trends over months or even years and is less reliable on assets that frequently flip the trends, such as futures assets.
Being careful, especially on currency FX assets where the extensions can go in significant moves if the trader does not cut losses since currencies are not bound by % moves like equities, and trends initiated by extensions can go much longer than most anticipate. Specific markets or assets need an extra careful approach to extensions.
An example of an asset where bullish extensions (an extension with push upwards) should be avoided traded is if the asset is in:
-has a strong bullish bias on PA, where every low is bouncing higher
-has a fresh, strong bullish catalyst
-has unusually large volume participation (lots of fresh buyers)
Bullish extensions under such conditions tend to fail more frequently (by failure, it is meant that the price keeps extending higher without delivering rejection/retrace), such example being ticker TWLO:
The steepness of the move
The steeper the progression of price the better, ideally all judged from 1 Minute time frame. Softer slopes signal the too slow progression of price and should be avoided. The slope should be measured from the base where the extension is initiated to its current last candle (consecutive bull/bear candles).
The steeper the move the less time it took to complete it, the less time it takes, the lower the chances for limit bid to stack under the price and "bucket" the sellers once they come (for short setup, use reverse meaning for bull play). That is why if the move is grinding up very slowly the limit buyers have more time to stack the order book with limit orders on the bid and prevent sellers from smashing through.
Volatility is the key indication of trade-able or non-trade-able extension
The crucial variable that indicates a higher chance of bounce, and a higher chance of liquidity pocket to establish is the scale of volatility. The scale itself cannot be measured by indicators (ATR etc...) because it is not the absolute number that matters, but rather the number or scale in relation to what volatility the asset trades on average. A trader needs to measure the volatility of the extension move by comparing the speed/strength/size of candles to the previous price action of the intraday chart (1,2,3 days ago) on the traded ticker to establish if volatility on extension move indeed is high or not. The higher the volatility the better. An example case where the extension move is on far higher volatility compared to what asset traded on the previous day:
Measure volatility to calculate correct R / position size
Measuring volatility on the potential traded asset is a must. One of the reasons why traders who often trade extensions have vast swings in P/L is because they either use a unified size approach on every trade (for example, one lot on entry trade or 1000 shares on every trade). They use the same scaling in / adding approach for every trade taken. This is a sure way to create large swings on the account and remove edge components from the trading itself since luck starts to play a significant role, which should never happen over 100 samples (well, at least in a perfect world).
To address this issue, check the first article on the blog about R sizing to understand why this is a vital aspect to understand, and this is required to equalize the impact that each trade has on account as much as possible. Using chart and eye only to gauge what might or might not be extended is not how to approach position sizing; there should be a combination of chart/eye and the math itself, and the math comes from a volatility scale.
Conceptual example, if a trader trades two extensions which on the chart all look identical in terms of the move itself, but if the same position size and adding of size are used on both, there will be a significant difference in P/L impact the traded account. This has to be avoided by measuring volatility and adjusting position size to it, combined with the price move on the chart itself (visually).
In ideal execution, every trade (if it is identical grade play) should impact the account as equally as possible in % terms. This means the dollar impact on equity should be equalized as close as possible. The above 2 examples are as far apart as possible, which is not the way how a trader should approach trading of extensions and their position sizing.
30% retrace target
The below image shows how the 30% target is measured from the base of where the extension started. Using micro consolidations to better help define such initiations of move or key breakout levels.
30% rejection/retrace target is measured relative to the whole size of extension move, conceptually shown below:
Also, to keep in mind, this is only a rough target estimate as per data (if the setup is isolated). Still, it is far better if the trader is using this setup in the context of some more extensive macro setup or using the tape/level 2 to better define more accurate targets per each setup depending on how price behaves. 30% retrace target is an ideal average take-profit target if the micro setup of extension is isolated from the rest of the variables on asset/ticker.
Completed 30% retrace target and adjustment of position afterward
Once the initial retrace target is reached trader should re-adjust or scale out a portion of the position even if unable to fill at the preferred target price, as statistically, the secondary move has a decent chance to happen after that, especially if the price consolidates for a while.
An example is shown below where a 30% rejection target was met from top to bottom. Theoretically, a trader should take this distance into account even if the fills on his/her position are not perfectly at where the current top of price is. 30% retrace is not measured from traders' position entry; instead, it is always measured from the current top of the move.
Trading extensions, as outlined in this article, are not about catching the trend reversal with a huge move. Instead, it is about capturing that 30% retrace of the extension leg and capitalize on that. Extension trade can be used as micro within a larger macro concept where a trader will use extension entry for potential 5+R trade. Still, there should be solid reasons outside of just extension itself for a trader to justify such a large target on trade.
This article touches only on approaches with extensions that limit the profit target to approximately one or a maximum of 2 R per trade. Anything else above that, if stretched higher, a trader needs to have solid reasons for doing so, else the win rate drops significantly.
Personally, if my covers are missed (for short play) and price re-bounds higher, my approach is to scale at least half of the position at break even on retest back and usually the rest half of position at break-even or slight loss, especially if the price keeps consolidating.
Below is outlined such approach conceptually (again, those are just my methods and by no means a must follow):
Ideal hours for extensions
Certain assets have clustered time zones each day where the amount or the degree of extensions will be higher relative to other hours of the day. However, this completely depends on the asset class. Below is an outline of which assets have clustered extensions usually around certain hours:
-Equities: Open hour of first 45 minutes for each market (US, EU, Asia...)
-Crypto: No time clustering, any hour of the day is just as good as any.
-FX: No clustering depends a lot on macro conditions and the time of year.
-Crude: Usually, the first 30 minutes of US market open.
-Futures: First 1 hour of US market open.
Using micro combo setups along extensions for better accuracy
To scale in a position with tighter risk a good way to approach it is by using combo setups of a smaller scale. Usually, those are tape/level 2 indications of strong orders, absorptions, or any other combinatory setups that overlap at the same time with extension. An example of such a combinatory setup of the micro stall of weakness is shown below.
Such opportunities are not always present, which is why in the majority of cases traders should start to participate with smaller sizes (feeler) ahead since expecting every situation to provide a combo setup would be very frustrating as it does not happen in the majority cases.
Using alerts wisely
Extensions are well supplemented by the use of alerts, especially for a trader who is trading multiple assets simultaneously. Alerts placed at the suitable price locations can reduce the amount of time that trader needs to input on each ticker; they increase the patience since a trader can set a strict price alert at which point he/she qualifies the extension to be trade-able while excluding the rest of development of potential or non-potential setup.
It is very common to see that traders who do not use alerts and keep staring at the same ticker for a long time are more likely to jump the shot too quickly. Alerts will keep you fresh and force you to wait for the extension to be closer to its "perfect" setup window rather than being too early when it might still be a B play or not even that. Mental capital will be better spent searching for other opportunities while the tracked setup hits the required alert to deserve its attention.
My personal preference is first to identify the price moves that can develop into an extension move. Once such a move is identified in its "infancy," the general approach I use is to set 3 price alerts all spaced out at even price distance above the current price move (if looking to short the bullish extension).
The first (lowest) alert will trigger to let me know that the asset should gain attention, while the actual entry alerts are only second and third alerts, which both need to trigger before the entry becomes valid. The process is outlined below in image:
Using an automatic / script screening system that seeks potential plays is also a good idea. For example, TC2000 and many other charting platforms allow the creation of such a filter/alert system, but essentially trader should still combine the use of alerts with such a system to manage a few assets or setups at once if needed or to better sharpen the automatic search system itself.
Extensions are a decent setup to populate playbook with since it allows a high number of opportunities across many markets each day; this makes it ideal not just complimentary play but also leading play for traders who prefer to focus only on one or two trading methods.
To capitalize on the extensions, it is essential to use alerts well or using a scanning software that has the search function well made. Without the use of alerts or decent search filters, it is more likely to miss the play. Or tracking extensions only on the assets watchlisted by the trader, where specific macro reasons are present to initiate trade is even better.
The downside of trading extensions is, however, two-fold:
-subjectivity on patterns definition
-trading against strength move where the risk rules can quickly begin to stretch too much, especially for less experienced traders
To define extended move, it is effortless to get lost in the subjectivity of how to determine the movement in the first place, which is why having strict rules on what does and what does not define the extension is very important.
The rules outlined above are my own, but the trader could use those to build upon and create an even more strict set of rules to avoid any confusion or subjectivity even further. One should have a clear view of the rules since risk management will heavily depend upon that. The most common place where traders take huge losses is right in the area of trading extensions that are not specific enough and not well defined, where the trader starts trading against it too soon and keeps adding to position without any clear risk insight or even what to expect from the price move itself.
Eventually, the situation gets out of control and turns into a significant loss. And the majority of those situations can be avoided by having strict rules on how the extension is defined, being very selective on which extensions to participate in and which not, and what defines a potentially failed rejection. Those three rules are a must to establish for any trader before starting to trade extensions.