After the accumulation and expansion phases, most stocks enter the distribution phase of the security cycle. A stock begins this cycle as undervalued, but a change in its fundamentals helps traders recognise its true worth and the rally begins. The price rises higher within a bullish trend, and suddenly everyone is discussing and analysing the stock, and wondering how high it can go. When the company is on the front page of the market newspaper, that’s the first indication the party is over and the distribution phase is beginning.
The “smart money,” commercial traders and buy-and-hold investors, quietly gathered shares of the stock during the accumulation phase. When distribution rolls around, they just as quietly sell them, generally to amateur traders who depend upon the market newspapers for analysis, and who are seduced into believing the rally will continue.

This seduction is actually an easy mistake to make, because the distribution phase has much in common with the accumulation phase. The price begins to move sideways into a trading range, as the subtle selling pressure from the smart money prevents it from rising higher, and volume begins to wane.

In the distribution phase, however, the company’s fundamentals are seen as strong, whereas this strength isn’t generally recognised during accumulation. As well, the company itself may consider its shares overvalued. The distribution phase is when many stock splits and secondary offerings occur, as the company hints at such a belief.

To further distinguish between distribution and accumulation, it’s also helpful to examine the recent chart history. In general, distribution is preceded by an expansionary rally, whereas accumulation is more often preceded by a contraction, or mark-down in price.

Even with these indications, it can be difficult making this judgment call accurately, leading to a general feeling of caution amongst traders when the share price starts to move sideways after a rally. Here is where chart patterns can help:

•    If the price action forms a flag, pennant, or other continuation pattern, the trend higher may resume.
•    If the price sketches a questionable pattern, such as a symmetrical triangle, the bullish trend may or may not continue.
•    But if the price starts to form a double top or head and shoulders, caution is clearly indicated.

Once the distribution phase becomes clear, trend-following traders should consider exiting any open positions, at least until the next phase gets under way. Distribution may last for several months, allowing range-traders an opportunity to ride the share price higher and lower for a few rounds. As with any other range-bound stock, the distribution phase is best suited for trading with oscillators, such as the relative strength index, stochastics, or the moving average convergence-divergence (MACD).

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