Chapter 7
Absorption
Overview
Absorption is when price comes into an area where the market is providing a significant amount of liquidity and is willing to refresh that liquidity repeatedly. If there is more liquidity than there is interest in doing business beyond this area, then we may get a reversal of price. Absorption occurs across all time frames.
Identifying Absorption
Absorption is something that can be clearly identified in real time and is an actionable event. The first sign is responsive activity. We then need to see that responsive activity refresh repeatedly in the same area. Here are some of the characteristics of absorption:
Refreshing of bid or offer on the DOM
Tight cluster of volume candles
High concentration of volume at price
High concentration of +/- delta at price
Delta Markers from OFL Delta Map Study
It is important to give absorption a bit of time to develop. We don’t want to be too quick to categorize responsive activity as absorption.
Absorption Reversals
The refreshing of liquidity on its own is not enough to cause a reversal. We also need to observe a change in the initiative activity away from the area of absorption. This initiative activity in combination with positioning becoming off sides at the area of absorption, can lead to acceleration and a reversal of price.
It is good practice to take into consideration the amount of volume that was absorbed when predicting the strength of the reversal. For example, let’s say have an open drive up that is met with absorption, causing us to develop a “P” shaped volume profile on the session. The next day, sellers push through the bottom of the “P” part of the distribution and it begins to accelerate down. Since we spent the majority of yesterday’s session putting in volume from the absorption, you can expect to get a significant amount of range on the reversal.
Practical Application
Absorption is one of the things we want to see when we are interested in starting a position. The first thing that will happen is a “pause” in price. This just means that we have momentarily stopped moving in the direction we were just going.
Once we see the pause, we are looking for responsive activity to become more aggressive. At this point we should have a starter sized portion of risk on. If this is in fact absorption, the responsive activity should refresh upon each return to the area. These returns to the area are opportunities to scale up our risk.
On the flip side, Absorption will have us scaling out of risk as well. If we are in a profitable position and we see Absorption working against us, we will begin to take some risk off and be happy to add back later if something changes.