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L-W Low Supply Level

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FIGURE 4.10 Reliant Energy, supply analysis. The supply analysis will help to point out unusually low supply patterns, where any significant purchase by a large fund will put pressure on the price to increase. Above the medium supply level of 20 percent, shares are available for sale in high enough quantities to satisfy a large fund. Hence, the buying by large funds above the medium supply level may not necessarily result in a price increase.

terms of trading performance; I found out that the optimum low supply level is not 10 percent, but rather between 5 percent and 7 percent. This sensitivity analysis is explained in Chapter 6.) 2. The medium supply level is set for a supply that is between 10 percent and 20 percent of the total issued shares. Twenty percent is relatively low compared to the total number of issued shares, but it is already twice the low supply limit of 10 percent. By experience, this 20 percent level is the maximum limit at which one can say that there is a potential share availability problem. Do not forget that if there is a lack of shares available, any fund that wants to take a significant position will need to push the price higher to attract the new supply.

3. Above the 20 percent limit, we can say that a fund will be able to take a significant position without having a real impact on the price.

In Figure 4.10, I have also pointed out two zones of high price, zone A and zone B. Although these zones correspond to high supply zones, it is difficult in my experience to establish a correlation between the possible selling pressure on a stock and the supply level. In other words, a 70 percent supply level does not offer a much stronger selling pressure than a 50 percent supply level.

The Case of Tellabs (TLAB) Tellabs also shows two interesting low supply zones where buying would have led to a significant profit. (See Figure 4.11; refer also to Chapter 2, Figure 2.7a and b.) In this example, it is also important to note that the peaks of supply do not necessarily correspond to selling points. A peak of supply simply indicates that shares could potentially be made available for sale. However, what will trigger a selling move is a price pullback. Indeed, when supply is high, it means that most shareholders are turning a paper profit of 15 percent or more. A price pullback will attract these shareholders into selling, in order for them to protect their profits. This selling pressure will be either a temporary pullback or a real new downtrend. Once again, as we saw in Chapter 3, the Effective Volume tool and divergence analysis will give you a much clearer picture of where you stand. In the lower panel of Figure 4.12, I indicate the buy zone 2, as calculated by the supply analysis tool represented in Figure 4.11. The upper panel in Figure 4.12 indicates that the downtrend 1 in Large Effective Volume was preventing us from buying the stock, even at a low supply level. It is only when large players moved in (as indicated by the small uptrend 3) that the trading rules allowed us to start buying.

The Case of Openwave Systems (OPWV) Figure 4.13 shows how dangerous it can be to trade only on the basis of the supply signal. (Refer also to Chapter 2, Figure 2.16a and b.) You can indeed see in the lower panel that the two correct buy signals (buy zone 1 and buy zone 2) are followed by an incorrect buy signal (buy zone 3). A catastrophic drop in the stock price of Openwave Systems triggered this incorrect buy signal.

FIGURE 4.11 Tellabs: supply analysis. This example clearly shows that the peaks of supply do not automatically correspond to the peaks in prices. Also, notice that the buy zone 2 came too early in the downtrend. This shows that other tools such as the Effective Volume tool are necessary to select the best entry point.

FIGURE 4.11 Tellabs: supply analysis. This example clearly shows that the peaks of supply do not automatically correspond to the peaks in prices. Also, notice that the buy zone 2 came too early in the downtrend. This shows that other tools such as the Effective Volume tool are necessary to select the best entry point.

Unfortunately in this case, the Effective Volume could not prevent us from entering during the Large Effective Volume uptrend B in the upper panel of Figure 4.14, just before another price collapse (downtrend C in the lower panel). This is the reason I also use the rule to buy when the price is above its 9-day simple average. This avoids being trapped into most of the catastrophic situations.

FIGURE 4.12 Tellabs: Effective Volume analysis. The Effective Volume tool excellent complementary tool to the supply analysis tool.

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FIGURE 4.12 Tellabs: Effective Volume analysis. The Effective Volume tool excellent complementary tool to the supply analysis tool.

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One of the problems with the Large Effective Volume analysis is that we cannot discern if a buyer is buying the new-found value or if he is simply covering a short position. We all know that large down-trends attract short-sellers. The owner of a share is always more eager to take action (sell) than someone who does not own it (yet who would be eager to buy it). Therefore it is probable that after a long down-trend, the first buying signs will be due to shorts covering their position. As we will see in Chapter 6, this is the reason why we need to look at the Large Effective Ratio signal that we studied in Chapter 3. Indeed, the Large Effective Ratio allows us to compare the present share accumulation to past accumulations, and this comparison allows us to judge the real strength of the buying movement: short covering must be accompanied by genuine buying in order to produce a significant signal on the Large Effective Ratio tool.

FIGURE 4.13 Openwave Systems: supply analysis. The supply analysis cannot distinguish between a low supply signal that came from a normal pullback in price and a low supply signal that happened because of a large catastrophic reversal. Other tools such as Effective Volume or the Effective Ratio are necessary to avoid untimely entries.

FIGURE 4.13 Openwave Systems: supply analysis. The supply analysis cannot distinguish between a low supply signal that came from a normal pullback in price and a low supply signal that happened because of a large catastrophic reversal. Other tools such as Effective Volume or the Effective Ratio are necessary to avoid untimely entries.

The supply analysis signal is a very useful tool that gives unexpected (but good) results when used in combination with other tools. We will see in Chapter 6 how this signal can be used in a successful trading strategy.

Before going into the real world of how to make money, it is important for us to briefly study how funds get in and out of investment positions, since they are the ones that provide liquidity to the markets.

FIGURE 4.14 Openwave Systems: Effective Volume analysis. Figure 4.14 shows that the Effective Volume analysis does not always prevent wrong calls. The Large Effective Volume issued a buy signal inside of buy zone 3 indicated by the supply signal. Both signals proved wrong later on.

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