Supply Testing Maximizing Profits in the Financial Markets

In volume spread analysis, testing supply is by far the most important of the low-volume buy signals. The high probable moves when testing supply appears are usually after there’s climatic volume.

What is a test and why do we place such importance on this action?

When professional money is accumulating an instrument they can mark prices down with some confidence. The issue professional traders face is that they can’t mark prices up when other traders are selling into the same market. Doing this will cost them dearly and is extremely poor business. If the professional trader persists with this type of trading it’ll eventually lead them to bankruptcy.

If professional money is optimistic and buying in a market, the entry of new sellers (supply) can cause problems. When prices rise, selling can act as a resistance to further increases, and if there is too much selling, it can overwhelm the buying and cause prices to fall. The bullish professionals may have to buy even more to maintain the high prices, but if the selling continues, they may end up purchasing stocks at a very high price and lose money if the market declines.

Supply Testing, Is There Anymore Floating Supply?

 Testing Supply (chart courtesy of TradeGuider)
Testing Supply (chart courtesy of TradeGuider)

In essence, when there is a supply of stocks in the market, rallies in stock-based indices are typically brief. However, professional traders can remove the floating supply by waiting for a long period or by rapidly marking the prices down to challenge the sellers and determine the amount of selling, known as testing supply.

Low trading activity during a markdown indicates minimal selling, and it can also catch stop-loss orders below the market, which can be a way of buying at lower prices (known as a springboard). Supply has to be entirely removed before professional traders can trade up their holdings.

The presence of high volume or activity during a mark-down indicates that there is selling or supply in the market. This process is called supply testing, and it can occur on low or high volume, often during bad news. Testing can catch stop-loss orders and shake the market, making it easier for higher prices.

Successful supply testing is a sign of strength, indicating that the market is ready to rise immediately. But a higher volume test usually results in a temporary up-move and may be subject to a re-test later. This pattern can create a “W” shape, sometimes known as a “double bottom,” and occurs when an area with too much supply is re-tested.

When are Higher Prices Likely?

When a down-move reaches an area of previous selling and then regains to close near the high on lower volume, it is a successful test and a clear indication that higher prices are highly likely. Lower volume suggests that there is now little selling compared to before. It is crucial to observe how market-makers and specialists respond to this apparent strength in the supply testing phase.

In a weak or bearish market, a test may occur, but if the market does not respond as expected, it indicates further weakness. The market specialist will not fight the market and will withdraw from trading if there is no response.

If a test does not lead to higher prices, it suggests weakness in the market. If it were a true sign of strength, market specialists and makers would have stepped in and begun buying, leading to an upward-trending market.

Old trading ranges form resistance areas due to known supply levels. Traders who previously bought into the market within the old trading area are locked in by a down-move and now represent potential supply or resistance to the market. Their main concern is to sell and recover as much as they can, without incurring losses.

Market-makers know where resistance areas are and if they anticipate higher prices, they will want a rally. However, the problem for market-makers is how to avoid being forced to buy stock from locked-in traders at what may seem to be high prices.

Supply areas in the stock market are like toll gates blocking higher prices from selling traders. Specialists aim to avoid or reduce this fee by absorbing selling to achieve higher prices.

How Market-Makers Cope With This Problem?

: Pushing up through Supply (chart courtesy of TradeGuider)
: Pushing up through Supply (chart courtesy of TradeGuider)

Gapping up rapidly through a supply area signals stock market strength. To avoid high-priced purchases, specialists encourage locked-in traders not to sell by quickly driving up prices.

When an old area of supply is rapidly risen through by the market, a profit is shown by the traders who were previously locked in by a down-move and were potential sellers at that level. It may tempt them to hold on to their positions. However, this could lead to them being trapped again at even higher prices in the future.

Gap up through resistance on wide spreads: a strategy by market-makers and specialists to reduce stock purchases in sustaining rallies. This strategy bypasses resistance toll gates where locked-in traders may want to sell. This technique is a tried and tested maneuver and can be applied to any chart, on any timeframe.

High volume and wide spreads signal pro traders absorbing selling by locked-in traders. Higher prices are anticipated and bullish sentiment is reflected by market-makers through what is known as absorption volume. This can lead to a new wave of buying, short covering, and encourage traders to start buying. If there is low-volume supply testing or down-bars after this event, it is a strong buy signal.

Trading in the Shadow of the Smart Money

The ebook exposes the influence of smart money in all markets and offers trading strategies to help traders align with big players. It simplifies market workings and charts, providing easy-to-use trading setups for any market. The 200-page ebook with full-color charts is a valuable resource for both new and experienced traders. [read more]