Supply Side Trading

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  • on April 13th, 2013

As it always does, this year’s MTA Symposium provided a window into the process of price analysts of all stripes. My pal JC Parets already delivered a killer review of the event; I’ll share just one nugget that I think cuts through the BS spewing out of most market commentary.

At the 2008 event, I was lucky enough to hear Hank Pruden discuss how modern traders can use the bedrock principles of early 20th century speculator Richard Wyckoff. This time around, he was there to take in the event but his lieutenant Roman Bogomazov gave presentations on the Wyckoff method in breakout sessions. I recommend this short read for an overview, but the approach can be broken down as follows:

a) Law of Supply and Demand- which side has control?

b) Law of Effort vs. Results- are they vulnerable to losing that control?

c) Law of Cause and Effect- has there been sufficient turnover of the shareholder base?

Going through slides, Roman commented that analysis of longs should always start with an assessment of supply. A comment easily lost(though I know Jon Boorman grabbed it, too) in the midst of his chart discussions, it became my greatest takeaway from the conference. Why?

I think it represents everything that is right about price analysis, and everything that is wrong about media narratives. The presence of low supply means an absence of a juicy story, and thus can get ignored. But for me it is the critical factor in finding low risk trades, and on occasion having one of those turn into a high reward trade. Consider the following graphic of what can move a market:

Supply

 To make money by anticipating high demand, we’re saying something needs to deviate from normal. Buyers need to become less patient, or larger, or sellers need to step away. That said, it’s entirely possible that sellers may be just as impatient and just as large and thus, an offsetting force. By contrast, a low supply approach allows us to profit from normal, everyday demand, and catch lightning in a bottle if for some reason that demand expands.

So how can we measure this minimalist form of analysis? Let’s hop into the mind of a fund manager, and consider the following reasons we may sell:

1) Overvaluation- price discovery leads to higher prices which prompts us to take our profit

2) Relief- having started with losses, we(and everyone else) are so relieved to get back to even that we sell and move on

3) Performance- planned(stop losses) or not, we can no longer tolerate the drawdown and accept our outcome

4) Conditions- whether forced by redemptions or by internal controls, across the board sales must be made even in our favorites

5) New information- planned(earnings) or not, the facts have changed and we act on the updated story

Surely there are others, but let’s start there…how do we measure supply based on those items? I can’t speak to fundamental changes as it’s not my area of focus. That said, I have my own ways of measuring a) extreme trading “valuation”, b) areas of past high turnover, and c) high/low hugging that can guide my analysis of the supply/demand balance. Add my d) measurement of market climate, and I’ve reduced my vulnerability to one…new information. A big one, yes, but unless you’re playing some other game you’re subject to the same(though on stocks, even that can be reduced by simply participating only in the days after earnings).

Yet nearly every article or pundit interview revolves around the high demand or high supply issue. When will $AAPL regain its momentum? How much higher can $LNKD really go? Is this new QE in Japan really going to stimulate its economy? When will the Great Rotation cause bond yields to spike higher?

I’m sorry, but these answers are just not knowable, and thus a total distraction from operating in the present. We don’t need to know any of these answers to make money; we can start by simply recognizing the character of the present ownership. Markets can go up on light volume, and the dollars spend just the same as the high volume ones. I’d rather recognize an absence of lows, than forecast an explosion in highs. Unless I’m managing at least 10 figures, I can still get my plan executed ahead of “the crowd”.

I’m sure someday soon we’ll “know” why $GLD just got crushed. My answer? It was floundering as a “low investor demand” situation(rocks in a wet paper bag), and found fresh investor supply as its fall set in motion. Flash crash in 2010? Same thing, a market with low demand that was overrun by the slightest increase in supply. Conversely, did struggling companies like $BBRY and $HPQ double from their lows because of great business improvement, or because months of selling exhausted itself into what became low supply stocks?

From my perch, better to constantly ask “Is this a low supply situation?” than “Will this be a high demand situation?” One prompts us to measure what is happening and one to measure what’s going to happen; in which of those do we stand a better chance of being accurate?

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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