Welcome to Market Profile Tutorial Series. This tutorial we will be discussing about Inventory adjustment process and how a trader can assess the short term inventory conditions so that they can remain objective by paying attention on what market generated information is telling you.
To Explain the Inventory Adjustment process let take an example of a Car Dealer. Let say XYZ Car Dealer started piling up a newly introduced branded car as the current sales are good and future outlook is promising. Car Dealer piles up inventory as automakers produce more cars than are being bought due to the prevailing retail demand. Too much of Inventory buildup but sudden drop in retail demand suggests either automakers will have to cut back production or boost discounts. In order to reduce inventory and convert into faster sales, XYZ car dealer provides discounts offers to liquidate his inventory. Similar style of inventory pile up often happens in the market also across the timeframes.
Inventory adjustment occurs especially when the market participants goes too long or too short. Short term Inventory Adjustment will be realized in the market either in the form of short covering or long liquidation breaks. Understanding the Long Term, Short Term, Day timeframe inventory conditions will give the true edge from both the trader/investor perspective.
Lets take a classical example from Bank Nifty Oct 2017 contract. In this example if you notice the structure of 5th , 6th, 9th, 10th Oct 2017 most of the days markets moved in a orderly fashion balancing and value area is building higher each day with the formation of prominent POC every day and the attempted direction of the market is up(market bottoms out every day on the first 30 minute – sort of panic buying situation rest of the day).
Prominent POC shows the presence of shorter timeframe players and multiple prominent POC back to back suggest the rising inventory with the presence of short term longs. Correlating the events one can sense that short term inventory is now went long to too long. Next day (11th Oct) Bank Nifty opens gap up followed by a strong liquidation break(deeper cuts) with higher volume during middle of the day where the old buyers turn to sellers and it goes like a avalanche process liquidating their open positions thereby inventory attain its fair equilibrium point.
Long liquidation is nothing but one form of inventory adjustment occurs especially when the market goes from long to too long. Often in a bull market it is played by smart money to generate fresh liquidity (make the old buyers to sell and trigger new sellers to enter and trade against them) and to remove the weaker participants from the market.
If you are not aware about the inventory conditions often you might end up getting trapped at wrong trade opportunities and you will be seeing only what you want to see from price/volume based indicators. In the next tutorial will talk about how short covering happens when the market goes short to too short.