fumoy,
here's an extract from the book 'Master the Markets' on testing. It's written by Tom Williams, a man who has done much to bring Richard Wyckoff's excellent, time tested work into the computer age. The book can be found easily on Google for free and is excellent resource for those trying to understand the market. No need to purchase anything so pay no heed to any sales pitch stuff. You may find that some others will contribute too as there are some highly knowledgeable posters on HC who are very generous with their time and knowledge.
Of course, there are many differing and somewhat opposing views out there, so it is possibly best for you check out the book if you have the time and see if any bells start ringing. I read it initially, didn't get it and put it away, read it again after getting smashed on a few bad trades and the lights went on, I knew this time exactly what Tom was banging on about.
Testing Supply
Testing is by far the most important of the low volume buy signals.
As we shall refer to the subject many
times, in what follows, it will be worthwhile to digress here for a moment and look at the subject in detail.
What is a "test" and why do we place such importance on this action?
A large trader who has been accumulating an individual stock or a section of the market can mark prices
down with some confidence, but he cannot mark prices up when others are selling into the same market
without losing money. To attempt to mark prices up into selling is extremely poor business, so poor in fact,
it will lead to bankruptcy if one persists.
The danger to any professional operator who is bullish, is supply coming into his market (selling), because
on any rally, selling on the opposite side of the market will act as resistance to the rally and may even
swamp his buying. Bullish professionals will have to absorb this selling if they want higher prices to be
maintained. If they are forced to absorb selling at higher levels (by more buying), the selling may become
so great that prices are forced down. They will have been forced to buy stock at an unacceptably high level
and will lose money if the market falls.
Rallies in any stock-based indices are usually short-lived after you have seen supply in the background.
The professional trader knows that given enough time (with bad news, persistent down-moves, even time
itself with nothing much happening) the floating supply can be removed from the market, but he has to be
sure the supply has been completely removed before trying to trade up his holding. The best way to find
out is to rapidly mark the prices down. This challenges any bears around to come out into the open and
show their hand. The amount of volume (activity) of trading as the market is marked down will tell the
professional how much selling there is. Low volume, or low trading activity, shows there is little selling on
the mark-down . This will also catch any stops below the market, which is a way of buying at still lower
prices. (This action is sometimes known as a springboard)
High volume, or high activity, shows that there is in fact selling (supply) on the mark-down . This process
is known as testing. You can have successful tests on low volume and other types of tests on high volume,
usually on ‘bad news‘. This not only catches stops, but shakes the market out as well, making the way
easier for higher prices. Testing is a good sign of strength (as long as you have strength in the
background). Usually, a successful test (on low volume) tells you that the market is ready to rise
immediately, whilst a higher volume test usually results in a temporary up-move, and will be subject to a
re-test of the same price area again at a later time. This action sometimes results in a “W” shape. This
pattern is sometimes referred to as a “dead cat bounce” or a “double bottom”. The “W” shape results from
the action of re-testing an area that had too much supply before.
Any down-move dipping into an area of previous selling (previous high volume level), which then regains
to close on, or near the high, on lower volume, is a loud and clear indication to expect higher prices
immediately. This is a successful test. Lower volume shows that the amount of trading that took place on
the mark-down was reduced, that now there is little selling, when previously there had been selling. At
this point, it is now important to see how the market-makers and specialists respond to the apparent
strength seen in the testing.
If you are in a bearish or weak market, you may see at times, what appears to be a test. However, if the
market does not respond to what is normally an indication of strength, then this shows further weakness.
The specialist or market-maker is never going to fight the market. If, in his view, the market is still weak
on these days, he will withdraw from trading. The market will then be reluctant to go up, even if it looks as
if it should go up, because there was little or no selling on the ‘test’ day.
Any testing that does not respond immediately with higher prices, or certainly during the next day or so,
can be considered an indication of weakness. If it were a true sign of strength, the specialists or market-
makers would have stepped in and would be buying the market – the result of this professional support
would be the beginnings of an upward trending market.
