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Exhaustion as an Odds Enhancer for Market Reversals

By Brandon Wendell, CMT | June 07, 2016 10:01 GMT

Exhaustion as an Odds Enhancer for Market Reversals

One of the many rewards of being an instructor at Online Trading Academy is the interaction received
from students, both in the classroom and via email. The questions and challenges are what keeps you
sharp as a trader. By constantly recalling my knowledge and seeing trading concepts through the eyes
of new traders, it prevents me from becoming stale and makes me a better trader.

While teaching and trading live in the Extended Learning Track (XLT), this morning, a topic that kept
coming up was on candle shape and the importance of price arrival to a supply or demand zone. This
reminded me of an old email I received from a student.

“I want you to tell me the importance of how a price comes back to a level? What is the significance of
how it arrives, if it comes in like a glider plane or a lead balloon? I think what is important is how it
leaves but the arrival is an odd’s enhancer. I am a ‘why’ guy. So why is arrival so important?”

This is a great question and the answer highlights the true market forces behind price movement, fear
and greed. I want you to think about a flagpole. If I climbed to the top of that pole it would hold my
weight. However, as more and more people climbed up to the top of that same pole, eventually it
would bend and break from the added weight. Prices are similar. Stock prices rise because of demand.
The demand being greater than the supply causes buyers to outbid each other in an attempt to attract
elusive supply and climb the pole. At some point, the buyers have exhausted themselves and everyone
who wanted to buy has already done so or is prevented from buying due to the high cost.

Prices start to fall as fear takes hold. Most investors and traders will start to panic when the price starts
moving against them (market reversals) or their stops will be triggered. If there was a lot of buying
pressure and large green candles going into the supply level, there will be few buyers to stop the
collapse and catch the supply being dumped onto the markets from stop orders being triggered.

Compare this with a gradual climb that features smaller green candles and some small pullbacks to
shake out weak traders. As prices fall away from a supply level in this scenario, they will be met with
less stop orders and more buying pressure as the demand was not exhausted on the way up.
Stocks

When the approach to the supply level is slower and had smaller candles, price is more likely to break
through the level rather than respect it.

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Arrival to demand zones are also important. If you arrive to the demand with large red candles signaling
panic and fear, you are likely to have a bigger and better bounce. The large red candles signal that
everyone who wanted to sell has now exited the stock. When buyers step in they must raise their bids
quickly to attract a seller who may still be around.

Stocks

If the arrival to the demand zone is quiet, there are still many worried holders of the stock who are
looking to sell at a smaller loss when the bounce occurs. This added supply will mute the bounce of
price from the demand level.

Stocks

So one of the important odds enhancers for analyzing our trades is how price arrives to test the supply
or demand level.