This week, I have to give credit to one of my students from the Philadelphia office, Ed O’Neil. Ed came up with a phrase that best describes a phenomenon that occurs often in the markets. In the class, we had identified many excellent trading opportunities based on the Online Trading Academy core strategy. The problem was that as we waited for entry, price would often come within a penny or two from entry before bouncing from the supply or demand zone. Since our limit entry orders were placed at the proximal line of the zone, we were unable to enter the trades.
Ed said that price appeared to be “sniffing the zones,” and the phrase was born. It did indeed seem as though the price was teasing the level before turning just short of it. We decided to explore this more as it happened repeatedly when we were waiting for an entry at a high quality zone. When looking at the broad market indexes or even the ETF’s that track them, you will often see price turn just shy of a supply or demand zone. In my article, “Watching the Markets,” I discussed the technique of following the leader when it comes to the indexes. When the leader hit a supply or demand zone and turned it would often cause the lagging indexes to change direction at the same time, whether or not they too were at a zone. This explains why price may “sniff the zone” on an index or index ETF.
So why would individual stocks also experience this? Well the majority of stock will follow the price direction of the broader market index. If the index reverses at a supply or demand zone, it can also cause stocks to change direction at the same time. But this may not explain all of the “sniffing” incidents. When we are identifying trading opportunities, we look at past price for the origins of a strong move in price. We do this to trade in the same manner that the professionals do. When price returns to this level of strong demand or supply, we will enter our trade. In the case of a demand zone, there is a lack of selling pressure as we approach the strong wall of buy orders. If the sellers have completely disappeared prior to price hitting the demand zone, prices may not hit the proximal line and instead turn just prior to the zone. This is price sniffing the zone.
You are likely wondering how you should deal with this zone sniffing. If you are watching the leading index but trading a laggard, you may want to place your entry or exit order just in front of the zones to increase your chances of betting into your trade. When you are trading an individual stock, watching the broad market index or sector leader may give you a clue on when you have to enter more aggressively. On any individual position, you take, you should be rating your trade based on a set of objective criteria. In the Extended Learning Track, our students learn these “Odds Enhancers” and are even provided with a worksheet to rate their trade. When there is an extremely high rating, the supply or demand level is very strong. Instead of entering with a limit order at the zone, you may be better off entering just in front of the zone to increase your chances of entering the trade. This will increase your risk as well since you are entering further from your stop. If you have found a great trade with a good risk to reward ratio, this minor adjustment should not hurt you.
In trading, we always want to be looking for a low risk, high profit, and high probability trade. Compensating for price “sniffing the zone” may be what your are missing to increase your probabilities for success.