Supply takeout / absorption
Updated: Sep 30, 2019
One of the consistent micro patterns present in very liquid markets is supply absorption / takeout around potentially bottoming price structures. Those patterns are common to all liquid markets such as large cap equities, Forex currencies, top 5 crypto, and futures. Certain aspects of this pattern are also explained in article "Trading ask stacks".
Consistency of behaviour and its change
Watching how structure develops is key to spot the critical moments when the behaviour changes and buyers start to press into supply / resistance by buying up offers. Generally if big buyers are aggressive at high price at active supply it is usually for reason, could be to remove the blockade and clear the path for general market, but there could be many other reasons as well, in some cases to set trap for longs.
For behaviour change first thing behaviour has to be symmetric, otherwise trader cannot spot it. Structure has to be clean with evenly positioned highs, with clear participation of offers around highs (tape, limit books).
Those patterns are relatively thin on edge, meaning that it requires patience and executing several plays in order for edge to come trough with positive performance. That is due to behaviour of pattern itself, aproximately 70% of patterns will form supply takeout and push, but only 60% will complete it with move that is over 1R in size relative to whole structural depth, or with other words if structure size is 10 pips, only 60% of patterns will actually form move that is 10 pips or bigger after pattern emerges with push. This combined with tight risk management creates softer performance expectation if trader uses 1% risk per trade, where 10 trades could potentially return around 5% gain if plays are executed well. It requires solid discipline to always respect the stops on play and being patient on profit targets otherwise edge decreases.
Frequency of play
This pattern is frequent in very liquid assets, across most markets (6E, GBPUSD, MSFT...). It requires well set trade management and asset tracking plan, along with use of alerts to help trader decrease the screen time. Alerts can be placed at critical break or bounce levels before or after pattern emerges. Also volume alerts or tape (big bids or offers soaked) can be used to help with trading this pattern.
Introduction to the setup
Core mechanics behind the setup is supply and demand shift within dense bottoming or topping structure. Trader should be looking to catch the squeeze at the moment where the key shift inside the structure happens. The squeeze initiated from the sup / dem shift could be the case of large player absorbing on bid / ask large amount of orders to build strong position and form the bottom / top on the asset, or the move could just be the consequence of short squeeze that is initiated once major highs in structure are taken out. For the most part if either of above is true the setup should work pretty much straight away with minimal draw down, if there is substential counter move on critical setup confirmation point it is likely that dynamics for the setup are not there in the right magnitude and the setup will fail. For that reason those setups should be traded on relatively tight risk (relative to structure depth).
Basics of setup
Basic structure of supply absorption / takeout pattern:
Therefore for valid supply takeout pattern structure should have this components:
- clean stage 1 ahead of it
- does it have stage 2 (both of those stages are a must)
- does it have stage 3 (optional but its a plus)
- and the most important stage 4 which is a momentum takeout, or if not that at least a very clear micro shelf buildup with offers soaked at supply.
Always looking at the setup from this stage to stage perspective will remove traders confusion and help identify if the structural composition fits the play.
In reality the setups will vary conceptually how they look, its all about order flow therefore the grade of setup and potential of reward on it will also be very much determined from 3 "external" factors:
-consistency of symmetry -consistency of consolidation -heaviness of one sided order flow positioning (for example very strong short / offers positioning on the supply level of price).
That means the supply takeout setups are usually split in few different versions:
Several different versions of this setup will emerge in markets, based upon how the supply will be distributed inside the structure. The setups are presented for bullish plays mostly here but the same goes for bearish setups just flipped upside down.
Entry and trade management
First stage should be for trader to wait for structure to set up along the 4 stages explained above. Once this is confirmed trader should start planning the entry. For entry there is one major rule trader should follow: Always wait for whole area supply to be taken / absorbed before entering. Or with simpler words, all highs should be taken with price trading above them, before the entry should be considered. Simply for the fact that this will decrease chance of price being rejected again from the supply that it is struggling to take out if there are still some underwater longs willing to sell out.
Again those articles are not focused on "how to trade" or "must to do", because there are many different ways to always trade every pattern. The reason i am pointing the rule above is only because the statistical data overlaps very well with higher chance of supply to be taken out if trader waits for that absorption. This rule is simply based on chances of performance, rather than this being a must to do on how to trade it.
Second part should be setting your SL (stop loss), or at least being ready to cut the trade if it does not work out. Stop loss should be maximum 50% of last leg distance from high to low. No more than that, why? Because that is the average performance rate of winning setup, the draw down is lower than 50% of that distance, on majority of winning setups. This is based on hundreds and hundreds of setups that i have collected and tested all the behaviour data on them. Again its not a must to trade that way, it is just the most optimal way of following best statistical route. But at the end each trader can trade with own style as long as long term performance is there (for example some are much more comfortable buying on dip ahead of expecting the takeout, rather than waiting for "confirmation").
Trader can cut trade in 30,30,30% chunks, or one full 100% sized cut, always better to scale out, especially on FX markets where there are no round trip commissions, in equities if trader uses partial scale outs its better to always scale out on limit orders with adding to liquidity so that commissions are zero or low.
On taking profits, trader should be patient to wait for solid move to develop, at least 1 R size of whole structural depth or with other words 2:1 RR on trade minimum. Profit taking is a must to be taken partially in chunks! There is no advantage in taking profits in one single exit, partial profit taking always has advantage in edge. But again...do it with limit orders on markets that charge round trips like equities or futures.
To sum it up:
-always wait for all highs to be taken out before entering
-set stop loss at maximum 50% of last leg distance
-profit taking always in chunks of 2, 3 or 4 exit orders
Bellow is conceptual presentation of trade management on setup (left setup with microshelf for very tight risk, right normal - typical setup with slightly looser risk):
Should be noted that trader needs to have some macro reason why he is trying to buy the this potentially bottoming structure. There should some overlapping macro reason such as catalyst bounce, or trend rotation due to whichever reason. This is a micro setup only.
Also to note, this setup is not suggesting that trader should just be buying breakouts of where price starts to trade above 2 consolidated highs, that is overlooking what this article is about. There is more details that go trough into proper supply absorption setup.
The importance of last leg
Last leg that setup takes out the supply is very important, it should be very strong move, market maker needs to reveal hand and show strong initiation. There is no point trading those setups without strong demand shift confirmation because otherwise trader is doing too much guesswork on what price might do after it passes trough supply. Thus last leg move (the one where price breaks supply) should be very strong and possibly on solid volume, or at least it should form microshelf at the supply area, showing that buyers are constantly soaking up offers at supply. Also tape should confirm strong buying at the ask, showing aggression of market. If last leg is not strong, trader should avoid taking trade.
Bellow are some setups with especially strong last leg where supply was breached on solid move and after that price squeezed:
Importance of symmetry
One of key drivers of this pattern is dense structure with established supply symmetry. What this means is that highs within structure (supply rejections) should be established within similar price area, ensuring that majority of short orders will be around similar price, using similar area to stopping out (good to fuel to move). If structure is not symmetric on the positioning of highs at least up to good extent it is not worth taking the setup, because there is less chance of cascade reaction move following, if the supply is breached. Again to point out, when structures are clean and symmetric more traders will look and take note on exactly same price levels, no matter of what kind of strategies they use. Symmetry draws all humans together when something is obvious and clean, this helps to create strong fueling moves often in markets.
Bellow is conceptual presentation of symmetrically distributed supply on left, and on right side example of asymmetrically distributed supply:
Rounding with higher lows rotation
Another good variable for A grade play is to have structure progressing from weakness (lower lows) into stronger bid (higher lows), while the highs remain equal. This rounding progress showing bids picking up at higher prices while pressure into supply remains even and present. Structure needs minimum 5 lows / highs in it for this effect to be visible. All those variables at the end matter for better quality plays as they stack on top of each other.
Such example with rounding bellow, but for demand takeout (flipped to supply takeout):
Statistical data count
Bellow is statistical count for time response and DD (draw down) on 125 A quality play examples of supply takeouts on FX currencies using strictly M1 charts, futures for volume data and tape (mostly collected during major surprising news events on dollar, pound, euro and few other exotics such as MXN and TRY).
What was included in this count is only setups with strong and clean symmetry of behaviour and also a strong momentum leg that performs the takeout (last leg in structure). What was counted is how long in terms of time it takes for price to respond in a direction that trader trading those two setups should expect and how much draw down was overall before the price hit the profits. Loosing setups were not counted in as it only matters for winning trades.
Data results strongly suggest that there is no point to use larger SL than 50% of whole last leg distance as data is heavily concentrated around minimal 10% or less DD (of whole last leg distance before takeout) on majority of setups. For anyone trading those two patterns this is very important data to recognize and validate in how risk managment should be handled,the way trader should manage trade, should be determined strictly from how pattern behaves (plus current Level 2 orderflow) and not what trader finds the most comfortable, otherwise the edge is decreased (but best natural method is to start with confortable risk management and then step by step start adjusting it towards what statistical data says). Forming trade management (where to cut losses or gains) should be result of: statistical pattern behaviour data + current live order flow aligning or disconnecting from it.
Data: 125 counted examples on M1. -100 examples performed with less than 10% of whole last leg distance of DD, which means minimal DD and price responding with strenght quickly into direction of expected move, which means 1 minute on most examples. That means 80% of examples fit such behaviour. -22 examples had DD between 20-50% of whole last leg distance and took them 2 - 5 minute before price went into 0 DD terittory and then hit the profits. That is total 17% of examples. -3 examples had DD between 50-90% of whole last leg, which took between 2 - 8 minutes before price hit the 0 DD territory and went into profits. That is total 3% of setups fit that.
To put the data on picture (same for both setups):
There is overall decent chance that if supply takeout is successful and delivers solid move, the price will bounce if that underwater supply is retested, in about 60% cases the price re-tests that supply. Trader can use that area for potential long entry play zone. Those re-tests and bounces can be often quite sharp and accurace, with price cleanly bouncing from major underwater resistance up to almost no under-over move. But that is not always the case, this is however common behaviour in successful bounces.
After the first bounce the statistical chances for next bounces to be sucessful decrease, with 2nd and 3rd bounce dropping in chance of delivering further bounces if retested. This is based on data of 570 collected samples.
This has been further explained on article "Underwater level rejection".
Bellow is conceptual example of first bounce:
Trade and setup examples of supply takeouts or absorptions:
Bellow example on AAPL ticker with large depth of supply structure, and then microshelf buildup into supply and strong consistent absorption of offers, until all offers were soaked and price popped up. This is ideal of how supply takeout setup should progress.
Bellow example of supply takeout play (using call options)) on SP500 index after FED rate cut announcement (buy the rumor sell the news and then relief rally play):
Supply absorption after down trend rotation on example bellow. When price behaviour becomes very consistent with progression it is easier to note from the price and tape when rotation is taking place (down trend into up trend) ,because it is easier to isolate variables. Microshelf around supply level in clear downtrend will often be the sign of rotation, as buyers are aggressively absorbing the offers at higher price. Notice how symmetrically the downtrend is progressing in example bellow, those kind of examples is what trader should be patient and wait for as on such samples behaviour change with microshelf stacks will be more cleanly visible, along with action on Level 2 / tape.
For example how trader could combo the setup bellow (ETHUSD) with macros is:
-having mid term catalyst that trader expects to push ETH higher
-having current M15 up trend, but on M5 price is taking pullback and trader is looking closely into M1 micro-trend when it might start to rotate with supply absorption for long play using the rules described above on article
-using tape for confirmation of entry
Bellow macro plus micro combo conceptual of the above setup on ETHUSD:
Bellow example of demand absorption (inverse of supply absorption) with clear overall weakness.