Beware of Distribution: Too Much of it in a Base Can Play Spoilsport

MarketSmith India_Learning Article

“For the best prospects, do a price and volume check of each week within the stock’s base to help you conclude if the stock is showing sound accumulation or too many price and volume defects. Next, do a fundamental analysis checking for excellent earnings, sales and return on equity..” – William J. O’Neil, MarketSmith Founder

In technical analysis, the process of identifying supply and demand in a stock starts with analyzing price and volume on the daily and weekly charts.

Are up days or weeks accompanied by heavy volume? Does the stock close in the upper half of the trading range, either on the daily chart or the weekly one? And on the down days, are they trading on light volume? If a stock falls on heavy volume, does it close in the upper half of the trading range? Answers to such questions in the affirmative strengthen the overall quality of a base pattern.

However, in some cases, the stock price might be volatile as the base takes shape, resulting in a “wide and loose” pattern. There might be a lot of institutional selling, in the form of distribution days or weeks, in the base. Both are negative and can keep a lid on a stock’s breakout.

One critical skill of a stock picker is the ability to recognize when a base is showing more accumulation (institutional buying) than distribution (institutional selling). Weekly gains on above-average turnover generally count as accumulation weeks; declines on above-average volume are distribution weeks. This definition of a distribution day or week in this article is slightly different from the way we see a distribution day as one where the market declines more than 0.2% on volume higher than the previous day’s, for the purpose of keeping a tab on the market trend.

Before seeing an example of how distribution has hinted at the weakening hand of the bulls, let us get into the nitty-gritties of this. If a stock rises, say, 5% midweek but ends the week up just 0.2%, can you still count it as an accumulation week? In our view, that is not good enough, as sellers clearly sought to exit the stock at higher levels.

Similarly, what if the stock had been down 4% at its lowest point during the week but closed virtually at the week’s high with a minuscule loss? Then it shouldn’t count as a distribution week either – buyers were around, lifting the stock off the lows. William O’Neil, founder and chairman of MarketSmith, has noted that if a stock finishes in the upper 60% of the weekly trading range and the trading volume is above average, it can count as a “support week”.

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