Distribution / weakness play

The distribution structure

This article will focus on outlining the overview of how distribution pattern looks, its formation and the two different versions of distribution patterns. There is also a list of variables on what is and what is not an A grade distribution pattern for traders to better distinguish between the lower quality and higher quality plays.

First, the structure has to have symmetric behavior with clear progression of lower highs, and the lows should be even (flat) or slightly higher towards the right side of the chart. Even lows are important if the trader wants to catch a key wash move (a quick drop of price) right on the making because even lows ensure a liquidity gap of the orders under structure once the demand is mainly positioned at support but not under it (easy to slice trough).

Both lows and highs should preferably follow trendline guide precisely, with no over-simplified drawings. If it is a trendline, then all highs/lows should follow it precisely. If they do not, it is not a trendline because only when something is very symmetric will it track the attention of many traders around the same price level. The liquidity gaps usually happen around symmetric structures, not asymmetric ones. If the structure is too asymmetric, it will create a too diverse exchange of opinions, which is not good for quick liquidation/slip moves.

Two different distribution patterns are shown on the conceptual image below, one after strength and one after weakness (where the first leg is a major selloff). Ideally, a trader should focus on the second pattern as much as possible (weakness) as the statistical rate of follow-trough is slightly better and can better suit macro content if the traded asset is in a major bearish trend.

Progressive weakness of buyers

The order flow concept behind the distribution structure is that buyers are drying up while sellers remain present and are pressing harder and harder. Therefore the main variable of distribution structure is progressive lower highs. Since the supply is in control, each bullish pullback is rejected and sent lower, creating lower highs. There should be no disconnect in the behavior of how highs are progressing within the structure, the more clean symmetry of progression towards the right side of the chart is, the better the weakness. By symmetry of progression, it is meant that each next high is lower than the previous high, and there is no high in between the structure that is higher than the previous one. Weakness should be mainly expressed through how highs are being formed over time and ideally just before there is a key breach of support, the price should linger and stall on support for at least some time.

1. Supply in control with progressive lower highs.

2. Buyers try to push, but each time is rejected at supply levels.

3. Symmetrical progression of lower highs, followed by lower highs.

4. Stall on support for some time to signal that buyers are completely dried.

5. Heavy wash after support breaks.

The example below shows the difference between the A-grade conditions on the left and the B grade conditions on the right in terms of the progression of highs (symmetry of progression).

Now trader might ask, well show me the case where there was such a perfect symmetric progression of price as in the left example? While yes, it does not happen often; the key takeaway is; it is about being patient and waiting for those setups to appear, and avoiding as many B grade conditions as possible. The more A-grade variables stack on top of each other, the better play it might potentially be.

A very common mistake with the trading of distributions from my personal observations is that traders force too many B grades plays into their trading executions, resulting in low performance on distributions. Having the right kind of selectivity is very important to increase the edge.

Bid / ask stall ahead of wash.

A grade plays on weakness will have a price stall before the wash of support ("floor wash") takes place. Distribution plays on strength do not have a stall in most cases; this makes distributions on weakness often easier to trade.

The stall on support is where the progression of weakness gets very clear, and the price is no longer able to bounce from support with any significant bounces (for example, only stock can only bounce 3 cents from support for 4 minutes). The stall is a critical component that can improve the timing of trading the distributions and also allows traders to tighten the stop loss and increase the RR on trade, it is the most important component present on A-grade example.

No liquidity or order flow below the support/structure

Those patterns are especially great to trade on large-cap stocks with strong downtrends where there are no significant bids/limit orders positioned understructure since in consistent and strong bear trend price is unable to create liquidity bellow (if it hasn't traded under structure yet).

Another example is also small-cap stocks that gap up strongly and then over time start to consistently fade with the clean backside, where price consolidates and breaks, consolidates and breaks lower and lower. As in the above large-cap example, there is no significant order flow under the distribution structure, and it is more likely for the large wash to come if key support is broken.

This lack of liquidity is one of the major reasons why so often once a key support buyer gives up, the price will flush through very quickly (which allows trader who is short to pack gains very quickly). The buyer who is trapped around support price (strong sized player) knows that he has to get rid of position quickly, before all other traders who are trapped at the same price as he is, as once support breaks, everyone will likely have to rush to the exit. The one hitting exit first will minimize the loss a bit, hence the wash reaction.

Example of the consistent downtrend on large-cap equity and no significant order-flow under distribution structure. A trader can observe this behavior with the use of order flow tools that display liquidity positioning visually such as certain futures platforms or Bookmap.

Below is similar example on the small-cap stock with backside and consistent dropping of price lower and lower where each time after distribution structure there is lack of liquidity under the structure.

Examples of distribution plays

Below is an example of weakness play on Bitcoin after the catalyst. Often best distribution plays, especially on currencies (crypto and FX) will be after the major catalyst, as key institutional players will slowly sell off their trapped position and use the current present liquidity to do so, which forms a distribution structure from time to time.

An example for small-cap stock on the image below for ticker SSNT. This example has a very consistent bounce from the support level, which is ideal, the more bounce the better as this creates a bigger liquidity gap area under support, allowing for a heavier wash once support is broken. The more bounces the better is a general rule to follow for distributions (3 is minimum, but ideally more is better).

If the asset has not been traded over a long time under the structural lows of distribution, there will be no major bid orders stopping the wash, that's why on such assets which don't trade for a long time under then structure with significant order-flow the wash will be strong and quick.

The structure should be as symmetric as possible in terms of how highs are progressing. The more consistent progression of lower highs is, the easier it will be for the trader to spot that critical moments or minutes when price begins to stall at support and bidders are gone, signaling a break of support ahead. That is a deal entry or add ahead of incoming wash.

An example of shorting distribution and entry positioning is taking half position short near current highs and a half of position at a stall on support; taking entry around highs is good for a higher average on short because shorting into support could deliver a bounce, however to time the wash well trader has to get comfortable with shorting into support, just minute (s) before the wash. It is a strange concept to get used to-shorting into support, but it really works if done correctly.

Below is an example of small-cap equities, ticker ATOS with the distribution structure.

Variables for A grade weakness on distribution for small-cap equities:

-is low float stock that is upon a day at least 30% (the more the better)

-has huge wash ahead of structure (impulsive bearish leg ahead)

-weak bid and large bulked offers on tape over past 15 minutes

-has consistent lower highs (each new high is lower than the previous)

-has at the end just last 3 minutes before it washes, tightening into bid-ask (price stall without any up or downtick)

-has large bid on tape around support level (often someone will be propping it up, preventing collapse, but eventually it will eat that bid on support and then crack)

-has a fluffy catalyst

The difference between A grade and B grade weakness/distribution plays is that on A-grade plays, it is possible to time the wash very accurately within a 1-3 minute time window. This allows for the minimal drawdown on position. If the asset is under SSR, it will, however, leave the trader un-filled on order in some cases. That is the downside of timing the wash on such tickers.

Another setup bellow on small-cap stock, ticker AXSM on dry liquidity:

Both ATOS and AXSM plays share certain A-grade play variables,m but as well lack some.

Below is an example of the Turkish lira; this one was untradeable due to too big a spread at that time and thin liquidity. The fresh directional bearish catalyst was another reason why to participate in such distribution short.

An example on large-cap ticker PINS, distribution, stall on the last retest of support, no bid on tape, and wash after. Just because the price is making lower highs, it does not mean by default that distribution structure is under formation. The usual main deal-sealer will be that stall on support without a bid on tape to identify the whole structure as potential distribution (plus tape/level 2 overall in structure with strong offers participating). That stall on support is often more important than the rest of the conditions present.

Bellow is example on ticker ARTW from February 2019. Clean setup (on lower liquidity) where price washed out very strong on key support breach. A general guide is the more times that price bounces from demand level and the longer it is consolidating in distribution structure, the heavier the wash will probably be, as more stop losses and longs will be flushed out on breach.

On this play, I was shorting around 3,30 with adds into 3,20 at bid stall. The covers were at 2,80 (too early). If the asset has a long-established distribution over 2-4 hours, then chances for large movements of price deeper are higher, and traders should be more patient on covering. The bigger the structure, the more liquidity is in it, and the bigger the liquidation wash can be.

Below ticker DCAR, B grade play on lower liquidity. Stall and no-bidon tape on the last retest of support. It is important to listen to behavior change for potential wash on retests of support.

Retest 1: bid on support

Retest 2: bid on support

Retest 3: smaller bid, but still there

Retest 4: smaller bid

Retest 5: no bid

Progressive weakness of bids as the structure keeps developing towards the right side. Could a strong bid just pop out of nowhere with market orders and push price upwards from support? Sure, it can happen any time. That is why risk has to be managed well when shorting distribution. The timing is key to get this play right, and developing a good eye for spotting the weakness is needed, which takes practice.

Below is example of B grade distribution on MMM:

Another example of distribution on weakness on YECO.

Below an example on NBEV, distribution on weakness with a stall on support before the wash of support. Notice the tiny three candles on support just before key wash, that is ideally what trader should be looking for on distribution structure, the micro-stall.

Similar, however, less clean example on ELLI. An example where price already stalled twice before last stall tat delivered wash. That is not an ideal example, ideally, the stall should only form once, and when it does that is where the price flushes support. If a stall formed few times in a row it means that one unexpected bidder keeps rescuing the ticker from falling, making it harder to tell when the structure will wash out.

Below is a decent example of ticker STNE. Price should be as liquid as possible for a trader to spot the critical weakness before a major wash is around, which is an example of STNE is not, as the liquidity is very dry and on low overall volume. If the ticker is very i-liquid, it will be impossible to spot that critical weakness often (gaps between candles and not enough action on tape).

Another low liquid example of distribution on ticker BMRA.

An example of a much higher liquid, better-graded distribution on crypto of ticker Litecoin versus Bitcoin (LTBTC). Notice the difference in the quality of price points, the volume consistency relative to the few examples above. In such distribution, the bid-ask spread will always be tighter allowing traders for better RR if shorting into support, which is a very important factor when it comes to trading distribution!

If the spread between the bid and ask is too wide at a support level, the trader's RR is by default minimized, as if price bounces one will have to cover short on ask.

A grade example below on crypto ticker Ethereum, distribution on weakness (after heavy selloff) with heavy offers on tape (didn't save the screenshots of tape) and then after break formed micro shelf and washed out further, basically combo distribution play, main distribution structure followed by micro-distribution, A grade.

Distribution or accumulation, which one is it?

One thing to note for distribution play is that sometimes it is difficult to tell if the price is under distribution or accumulation process, as tape and price structure itself might not give enough clues. This means that what looks like distribution play might eventually turn out to be accumulation play once the bidders push strongly and rotate above previous highs in certain cases. It is something that traders should take as part of the game; there is not much that can fix this problem, other than trying to only execute on A-grade patterns and exclude as many B grade ones as possible.

It is all a lot clearer in hindsight, but no trader makes consistent gains with only hindsight trades.

To help with this double-faced problem it is always good to trade plays that meet all required variables; this way, the confusion will be the lowest. Weakness play should have an expressive stall with weakness on support to help with identifying it correctly.

The face might be a face if only a few features such as eyes and ears are taken into account for definition, but to tell difference between a face of a primate or a human, it is about the details and composition that matters. The same applies to identifying the distribution and accumulation or to avoid mistaking the two.

Trade entries (suggestions only)

The price should to move in traders' direction quickly, and a trader needs to nail the wash within 5 minutes if one is shorting weakness of distribution structure. Otherwise, the risk/reward on trade is not worth it due to shorting into weakness/support and low entry average. Due to that, it is also always a good idea to split trade into 2 chunks and fill one starter or half-size around the highs and the second chunk when the wash is anticipated for a better entry average.

To be completely clear above said is just my preference on how I like to trade distributions and is by no means the only possible method. Every trader should shape the playstyle slightly fit to his / her own approach, but any changed variables should be properly tested to check if they hurt the long-term positive P/L expectancy.

Example of short entry on ticker Ethereum below with A grade distribution play after huge wash and fresh catalyst initially ahead of structure. Most A-grade plays will be after huge washes on huge volume. And the majority of A-grade plays will have micro shelf bid/ask stack ahead of its wash, giving traders a solid risk management area to focus on for nice RR. Shorting with a market order is often a must on those plays because to time the wash well (within 1 minute), it is often impossible to fill the limit on ask.

Another Ethereum example below did not trade this, but it stands for example of where the entry executions would be.

Additional entry or recycle on the underwater level bounce

Another great way to add back some covers and recycle is to re-short back on a retest of underwater demand/support level. This only applies to plays where there was a quick, strong wash of support, and then price came back to retest it relatively quickly. If it is not a quick wash, underwater bonce entry should be avoided; statistically, it has less chance to bounce. Trapped long traders need to see support break strongly and quickly this way if price retests support again giving them break-even opportunity, they are more likely to take it.

As with any underwater bounce play, the price should respond quickly and on point respecting the level; if it does not, it's time to exit the trade and cover.

Play frequency

Distribution plays, especially A-grade plays, are complementary plays. The larger the asset base that trader covers each day, the more likely it will be to find one play on daily basis. It is likely to see less than 6-7 decent plays per month (for example, small-cap equities only or crypto only). And this is why it is only complimentary play and not something that traders should exclusively trade or focus on. Only traders with great searching-hunting skills and a large sample base of trading instruments might be able to trade only distributions.

Also to keep in mind: Patterns usually don't go away; they shift the frequency at which they are spawned. Sometimes denser, sometimes looser frequency. Keep this in mind, if there is a month with many or very few distributions present in your favorite market.

SSR (short seller restriction on stocks)

Often distribution plays will form on tickers that are under SSR (short seller restriction). It is standard practice in the industry not to short SSR tickers on weakness because shorts can easily get squeezed if someone wants to push the bid. Statistically, the distribution plays on SSR names perform in a similar ratio as on non-SSR names. Therefore when it comes to distribution play specifically it is more the data performance that matters for a trader to follow, rather than following generalistic advice of "don't short the weakness".

Bid / ask tightening ahead of support wash.

Ahead of each wash on those distributions, the tightening of the bid / ask spread should be present, an important variable for traders to look at that could indicate aggression of sellers into support. To time the wash (if one short into weakness to catch the wash), this is an important variable to look, how the dynamic of spread moves as the aggression builds into support from the side of offers.

For example, ticker might trade with 8 cents spread on average across a 15-minute time span, but ahead of 70% distribution weaknesses, the spread will suddenly become much tighter (1-3 cents) just a minute or two ahead of wash. Sellers press into support (ask aggression), and the price slips after the bid are eaten. This behavior is widespread on weak assets, where there is not enough limit order liquidity under the support, usually, since the asset has not traded around those prices for a long time (news event on small-cap equity), or the asset is trading on the backside mode.

Conceptual presentation of the average bid / ask spread dynamics across the development of distribution structure (in approx 60-70% cases). Offers are stepping down and meeting the bidders before the major wash. If such spread behavior is present across structure development, then this is an A grade variable.

Timing the wash

On weakness distributions, sometimes it is possible to time wash well, 10-20 seconds before it happens. All variables must overlap well because if the trader shorts into weakness/support of any distribution pattern, the P/L will not be green over 100 sample repetitions. And if price bounces, one has to cut trade quickly if shorting into support.

Below are variables for potential strong wash on weakness distribution play and catching it just seconds to 1 minute before it happens :

1.Heavy wash ahead of structure

2.Bear legs in structure have strong selling (tape/ volume)

3.Progressive weakness that ends with last 2 highs to be a lot weaker than last previous high

4.Asset has dynamic spread, usually wider spread (micro flats)

5.Stall on support with no bounce for at least some time (1-5 minutes)

6.Last several minutes into a retest of support tape/level 2 is all red

7.No significant bids sitting on bid on the support

It also goes without saying that this is a trial and error approach. It is not as easy as it sounds, and one might get only 50-50% performance in really timing that wash; the important thing is to have patience on the RR side so that on the plays that are caught well trader is patient and on the ones where its bounce to cut loss very quick (sometimes even few cents are enough). A lot of practice is needed to develop a good eye for weakness overall; it takes time.

Conclusion

Distribution is really enjoyable to trade once the trader gets the grasp on "how to time the washes" well and breaches of supports with accurate timing. It might take some practice, and it might as well not be fit for every trader, since some traders have a very difficult time grasping the concept of shorting into support as their risk management just says it is too strange of a concept to follow. It is highly recommended to study distributions first on historical charts as much as possible as that is the first step required for traders to "build an eye for spotting the structure".