We are facing a market in distribution (another way of saying it’s undergoing a correction). Trading in this environment is tricky. While you may be tempted to buy into lower prices, you don’t want to jump on board before the bottom has been made. Because nobody rings a bell and announces, “We’re at the bottom (or top)!”, you need to move cautiously.
How to trade a market in distribution
A market in distribution occurs when institutions sell large amounts of equities. Thankfully, the timeline for distribution is much shorter than accumulation (when those same institutions constantly buy stocks). Instead of weeks or months, distribution typically takes place over a few days.
When sellers overwhelm buyers, it is perfectly OK to get out of the way and take a break from trading. However, you can choose to raise some cash and participate in the downside action. Just keep in mind that when institutions sell, the action tends to be swift, painful and chaotic. Remember what happened in February? Even though the markets have been riding an uptrend, the biggest moves this year were all to the downside.
My course of action is two-fold: I buy more index puts to protect my portfolio, and I write calls.
How to identify a market in distribution
I look at six indicators:
- Higher volume selling
- Option flow trends – are they bullish or bearish?
- A divergence between new highs/lows (this indicator started to break down in mid-September, an ominous sign that played during the big drop two weeks ago)
- Poor relative strength
- Horrible breadth levels
- Price action
Now, you can make an argument around accumulation or distribution by lining up indicators just so. If you’re not sure, look at price action. It is the final arbiter. When price levels broke on October 10 (we keyed on 2860 on the SPX 500), it was time to play defense. We quickly added puts, which paid off. We added more, which continue to working (as of today).
Markets don’t stay in distribution forever, but don’t try to guess when it will end. Play the markets accordingly, and eventually it’ll be time to go into accumulation mode.
