Distribution Dynamics

by Tyler Craig on March 8, 2012

In The Accumulation Elephant we explored the affect of institutional buying on stock prices.  In sum, the entrance of these behemoths to the proverbial tub resulted in an overall rise in prices.  If the bulls were in charge of the bathroom they’d coax as many elephants into the tub as possible.  After all, the more institutions joining the fray the stronger the underlying bid beneath the market.

Of course, there is a flipside to the metaphor.  What happens when these elephants become disenchanted with the previously tempting tub and decide to exit en masse? Given the removal of several massive elephant feet, the water level would have no choice but to fall.

In case the metaphor missed the mark, consider a more concrete example.

Suppose you are an institution looking to unload the 10 million share position previously accumulated (per my prior post) in a somewhat illiquid security.  While you would like to dump the entire position at the current share price of $30, it’s simply not possible.  There is insufficient demand to absorb that type of selling at the $30 level.  Similar to the accumulation example, you have two choices.

1.  If you value speed over price you could simply dump the stock on the marketplace as quickly as possible until the entire 10 million shares have been unloaded. While such a decision affords a swift exit, it only comes by sacrificing price.  Your relentless selling will single-handedly push prices lower until enough buyers are found.  By the time the selling frenzy abates prices may have sunk to $28, $27, or lower.

2.  In the event you value price over speed you could strategically unload your shares as the current demand in the market allows.  You might park yourself just north of the $30 level and sell into any strength that lifts prices into your zone.  If the market is merciful you may be able to exit your entire position at the desired price of $30.  Such an outcome would likely only occur over time though.

Unlike nimble retail traders which can exit markets with ease, institutions must of necessity unload positions over time.  This selling over time is often referred to as distribution.  The mere fact that the big boys can’t bail all at once means that once they start to sell, they will likely continue to sell.  Such incessant selling often acts as a lid on stock prices, halting each advance.  One simple way to identify distribution is to look for high volume down days.  Such an example recently cropped up in the Transport space (IYT).

In the end, the action of these elephants should shed insight on why traders take note when high volume days arise.

Source: MachTrader

{ 1 comment… read it below or add one }

Dmitry March 12, 2012 at 6:46 am

A good example of how technical patterns are formed, for those \not believing in TA\ :)

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