In the second article of this series, we’re going to look at compression and why it’s so important to supply and demand trading.
First, let’s look back at a basic principle. If you’ve been following my previous articles, you’ll know that the more a supply or demand zone is tested, the more likely it is to break. When price reaches a zone, some or all of the orders at that level get executed. When the orders at that level are gone, price breaks the level and continues to the next zone.
Now, bearing the above in mind… when the smart money wants to turn the market, they need to remove all the orders that are in the way. For instance if the smart money wants to go short, they will need to consume all the buy orders at demand zones below them. This concept is known as compression.
In this example on the EMini S&P future, the market wanted to go lower. In order to do this, the 2 demand zones marked on the chart had to be consumed. The red circles indicate where the consumption of buy orders by the smart sellers occurred. Once the buyers had been eliminated, price was free to drop.
Compression doesn’t always occur before a move, but when it does, it’s a big clue that the market could turn later.
Another way to think of this concept is to imagine a snow plough gradually clearing a path. Once the path is clear, traffic can pass.
The exact same idea works in reverse. That is, if the market wants to go up, it will consume sell orders at supply zones that are in the way.