We all know the importance of market status in determining an investor’s stance in the CANSLIM style. It not only helps you realize gains by being aggressive when the risk is minimal but also protects you from unwarranted risks of markets.
When the market is in a Confirmed Uptrend, it is the best time to make the most of your gains. This is when most breakouts are successful, and hence an investor carefully following the patterns of his/her stocks makes big gains. But how can you pre-empt a probable weakness in the market so that one can lock-in gains and play defensive with less or no exposure? A distribution day can provide a systematic and credible approach to do that.
What is a Distribution Day?
A distribution day is when a market representative index (for example, Nifty50) loses more than 0.2% in a day, with volume higher than that of the previous session. When a distribution day occurs, it hints that big institutional investors are exiting or reducing their positions in the market. Institutional activity is what moves any market, especially in India where retail participation is small. Though a distribution day hints at institutions liquidating their positions, it loses its impact after 25 trading sessions.
How Does it Help in Sensing Market Weakness?
On August 31, market status was downgraded to an Uptrend Under Presure. An investor should keep count of all valid distribution days during a Confirmed Uptrend. Successive distribution days imply a weakening market. But what threshold of distribution day count is enough to say the market is under pressure? A distribution day count of 2–3 is benign and usually normal in a Confirmed Uptrend. But when the count increases to 5–6, one should prepare to get his/her positions trimmed.
William O'Neil wrote in "How To Make Money In Stocks," "After four or five days of definite distribution over any span of four or five weeks, the general market will almost always turn down." When this happens, carefully assess each stock in your portfolio and reduce your exposure accordingly. And in some cases, it's wise to get out completely. Market rallies do not go on forever. At some point, they will end. This usually happens when the market gets smacked with a heavy load of distribution days.
Related: Webinar on How to Spot Market Tops?