How to Trade the Liquidation Phase? – [Part1]

In the financial markets, often a set of market participants keep on adding long inventory of a particular trading instrument during bull markets (long inventory pile up phase) over a period of time. At times the long inventory goes to the extreme which is often followed by the liquidation of those piled up inventories (liquidation phase). It is a trading good practice to understand which participants are piling inventories and who in the markets are cutting down their inventories.

Who Pile up Long Inventories?

1)Financial Institutions (Macro Funds, Long-Short Funds etc), large speculators (long term players)
2)Short term players (Momentum Traders, Trend Followers)
3)Small Traders – Mostly Speculative players

Sudden intraday drops in the markets are often more of liquidation rather than fresh money selling. In a typical bull market as the price rises, a set of market participants always tend to book profits followed by another set of market participants starts increasing the long inventory.

Long inventory pile up in Futures markets influences the price behavior on the upper side whereas Long Liquidation (Exit of Long holdings) of those piled up inventories often bring bear markets. It is more of a long liquidation brings the bear market than the shorts piling up. At times Long Liquidation will be combined with fresh money shorting that is where a serious downtrend emerges.

Liquidation phase can happen especially
1)if the market participants are in profits/deep profits then profit booking happens.
2)if the market participants are holding the positions for a long period and nothing happens in their favor
3)if the market participants got trapped at the highs and markets started moving against them.
4)fear in the markets (News based / Global markets selloff) – fear is what triggers the avalanche of liquidation. Participants are forced to liquidate as the other fellow participants are liquidating.

Markets change its dynamics often. If one fails to understand the liquidation phase it could bring potential devasting effect to their wealth. In the next tutorial we dig deeper into the liquidation phase.