Market Dynamics Part 2: How to Spot Distribution

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Welcome to the second part of our two-part series on market dynamics, where we explore how underlying supply and demand impact price action.

In Part 1, we examined how to spot the Accumulation phase of the market cycle, where institutional investors quietly build their positions. Today, we're delving deep into the Distribution phase, a crucial period where these same investors begin to offload their shares. We will reveal the subtle clues that can help you identify the Distribution phase and better align your trades with the market's natural ebb and flow.

The Market Cycle Revisited

Let’s revisit the Market Cycle that we introduced in Part 1. The Distribution phase is characterised by sideways price movement as the institutional 'smart money' begin to sell their shares without wanting to cause a drastic price drop. This phase in the Market Cycle model precedes the Markdown phase, during which selling pressure intensifies.

The Market Cycle

Past performance is not a reliable indicator of future results

Why Spotting Distribution Matters

To quote the American economist Michael Hudson, "Stocks always go down much faster than they go up. That's why it's called a crash." This highlights the critical importance of the Distribution phase in the Market Cycle. Recognising this phase early can provide traders with several strategic advantages:

Strategic Entry and Exit:Spotting Distribution early allows traders to adjust their strategies based on emerging market conditions. For instance, if you're already long on a stock, early signs of Distribution might signal the need to exit your position to avoid potential losses. Conversely, for short sellers, identifying Distribution can present an opportunity to enter positions before a significant price drop.

Optimised Risk Management: During the mark down phase, market volatility often increases, with price movements becoming more erratic. By identifying Distribution early, traders can adjust their stop-loss levels and risk management strategies accordingly.

Trade Management: Early identification of Distribution can enhance your trade management practices. If you're long on a stock and start to see signs of Distribution, it might be beneficial to exit early, locking in profits before the market turns.

How to Spot Distribution

Traders should think of the Accumulation and Distribution phases of the Market Cycle as a game of deception. Institutional investors are masters at disguising their true intentions. During Accumulation, they quietly build positions, while during Distribution, they gradually offload them.

Here are some key indicators to help you spot Distribution:

1. Clustering of Swing Highs
During the Distribution phase, prices often form a series of swing highs that cluster together, with each high struggling to make significant progress beyond the previous one. This clustering signals resistance, as selling pressure increases and buyers fail to push the price higher. This pattern reflects the market's inability to sustain upward momentum and is a classic sign of Distribution.

2. Long-Tailed Candles
Long-tailed candles, particularly those with upper shadows, indicate weak daily closes. These candles form when prices rise during the trading session but then fall back down, closing near the session’s low. This pattern suggests that sellers are stepping in to push prices lower after a brief rally, highlighting the growing selling pressure typical of the Distribution phase.

3. Tightening Trading Range
As the Distribution phase progresses, you will often observe a tightening of the sideways trading range. This narrowing range reflects a balance between buying and selling pressures but leans towards an eventual breakout to the downside. The reduced volatility and compression of price action are indicative of the market preparing for a transition to the Markdown phase.

By focusing on these three key signs, traders can potentially gain a tactical edge in anticipating price movements and aligning their strategies accordingly.

Practical Examples

Nikola Corp (NKLA)

Here’s a great example of distribution occurring in Nikola. Notice the clustering of swing highs and the failure to make progress past previous swing highs. Also notice how we start to see multiple long-tailed candles which highlight weak daily closes. We then see a break of the tightening range leading to a prolonged markdown phase.


Past performance is not a reliable indicator of future results

Netflix (NFLX)

In this example we see Netflix start to form a tight sideways range characterised by a series of small swing highs. Notice the weak closes as resistance starts to form. The distribution phase leads to a short sharp markdown phase.


Past performance is not a reliable indicator of future results

Conclusion

We hope you enjoyed this two-part mini-series on market dynamics. By understanding the Accumulation and Distribution phases of the Market Cycle, traders can gain valuable insights into the subtle yet powerful forces driving price action.

Disclaimer: This is for information and learning purposes only. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance. Social media channels are not relevant for UK residents.

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