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Timing The Market With Distribution

10/26/10 11:35:04 AM
by Billy Williams

Spotting distribution can help you spot stress fractures in the current uptrend and avoid losses.

Security:   SPX
Position:   Buy

Since the market confirmed an "O'Neil Follow-Through Day" in early September and despite the economic challenges in the US and abroad, the market as a whole has been surprisingly robust, moving forward slowly but surely.

However, it's important to remember that even strongly trending markets can reverse violently and if you're not prepared, you could lose all the gains that you've worked so hard for or worse, you could lose a lot of trading capital by not catching the warning signals that the trend has run its course and is about to move against you.

Almost all good momentum traders understand that to enter a strong stock as it is breaking out or pulling back in price, you must have the market in a confirmed uptrend to have the larger market adding to the momentum of the stock's breakaway move. Unfortunately, even if you do all that at the outset, you leave yourself vulnerable to violent reversals by not observing the larger indexes for signs of distribution.

Distribution occurs in the market where the trading volume on a given day is primarily from sellers combined with the fact that the price bar closes down at a loss for that day when compared to the previous day. In addition, it is considered a distribution day when price closes at or near its open combined with overall selling volume on that day. See Figure 1.

FIGURE 1: S&P 500. The S&P rallied in early September 2010, trending upward but still revealing three distribution days along the way. Right now, the market is healthy, but keeping track of days like these helps avoid losses.
Graphic provided by:
These are the days that the major institutions and hedge fund managers are selling into the upward momentum to lock up gains. This can be hard for the inexperienced trader to spot because it can be very subtle, and this is also why the big players in the market sell off their positions piecemeal over a series of days like this as to not alert the investment community.

The reason for this is that if the floor traders get savvy to what is happening, they will make it much harder for the big players to get out of their positions at a more ideal price. Likewise, if the rest of the investment community at large gets savvy to what they are doing, then it could result in a panic and cause a run on the stock, depressing the value of their shares.

Now, tops in the market are hard to spot but if you observe six or more distribution days in the indexes, such as the Standard & Poor's 500, over a six-week period, then you should become cautious. At times like these, you should consider getting out of the market altogether or, at the very least, start tightening up your stops on existing positions in order to not get caught in a trend reversal if the market suddenly changes.

Because the bigger players in the market have so much money and stock, they can affect the overall health of the market by selling off big chunks of their tradables in a given time. This can cause a correction in the market or even preclude a bear market. Either way, spend time marking off distribution days in each of the major indexes so that you can start to see if stress fractures are building in the given uptrend and make adjustments to avoid unnecessary losses.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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