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SP500 Price Extensions from 200 Day SMA Insights

Fri, Feb 11, 12:19 PM ET, by Corey Rosenbloom

What does it mean when someone says “The SP500 is really, really overbought?”

There’s many ways to measure “really, really overbought” objectively, and one of those is to compare the percentage price is extended from a certain moving average, for example the 200 day simple moving average.

Right now, price is just over 14% extended above its rising 200 day SMA, but what does that mean? Is that a lot?

The answer is yes, but let’s put that in context of the entire bear market and recent bull recovery to see past “overextensions” from the 200 day SMA.

Here’s the chart:

You may need to click to enlarge the chart (via Flickr).

By doing objective indicator analysis like this, we can easily quantify the current “overextension” relative to past “overextensions.”

Given the recent two-year history in a broader light like this, 14% is up there, but certainly NOT “really, really” up there by any means.

For example, the bullish percentage peak came in October 2009 when price moved 20% up above the 200 day SMA.

Notice that the indicator was just starting to turn up after price crossed this very important average initially (a very simple potential long-term buy signal) in June 2009.

Since then, price hasn’t been able to meet that percentage of ‘overextension’ because the average comfortably rose along with price.

This is why you tend to get big overextensions early in a price move and not towards the end… in fact, toward the end, this indicator will show divergences like many others (as was the case when the market peaked in October 2007).

Also, the current 14% extension is just over 1% greater than what we saw at the prior 2010 April peak (ahead of the mean Flash Crash).

Now let’s look at the underside from the bear market.

The “worse” it got was a 40% under-extension beneath the 200 day SMA at the heart of the financial crisis in November 2008.

The 40% number was followed shortly with a new index price low with a ‘divergent’ indicator reading at 38% under-extension when the market bottomed in March 2009.

So the quick conclusion is – always take indicator values and current situations in context of the broader picture/history.

An overextension 14% above the rising 200 day simple moving average is undoubtedly “a lot” – but it’s not the most price has ever been extended in recent history – neither from the bull or bear market in the last few years.

Corey Rosenbloom, CMT
Afraid to Trade.com

Follow Corey on Twitter: http://twitter.com/afraidtotrade

Order your copy of The Complete Trading Course (Wiley Finance) now available.

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