A Liquidation Break happens when the market gets itself overly long. The late majority and laggard buyers run out, then as the market begins to pull-back they panic sell their positions. This causes an abrupt drop in the market.
Recognizing liquidations allows a trader to avoid panic and choose the most effective response.
- They can be recognized by these characteristics:
- They often start suddenly and at a moment that doesn’t suggest a reason for such an abrupt and violent move.
- They are not news driven. Rapid tempo out of nowhere.
- They will retrace 100%. Normally relatively quickly, but sometimes as late as the next day.
In most cases liquidation breaks happen very quickly, they retrace quickly and the market continues to push higher again. This is because as Jim Dalton would say “sometimes a market has to break before it can rally”. The liquidation shakes the weak handed longs out of the market and brings in strong handed buyers who see the discount as an opportunity. So, by the time the market retraces 100% the traders holding the longs are mostly all in the profits, at the exact place the laggards were buying the overpriced longs shortly before.
Less often, but sometimes, a Liquidation Break can bring in “new money sellers” to the market. That is to say not just the longs exiting their positions but new traders going short with the momentum. This will bring the Liquidation Break to an end, and begin a new auction, usually to the downside.
Signs the Liquidation Break is over.
- Once the tempo slows for a significant amount of time and the market grinds at lower levels.
- If the market has dropped and retraced 100% and is now falling again.
- Seeing Volume build with the tick chart in the negative.
We see on average 1 to 3 liquidation breaks a week in the S&P 500 during US regular trading hours.