Consolidation patterns can result in some strong breakouts, and if traded correctly, can result in some stellar profits when trading stocks and options. When the market comes to an indecision in regards to the value of a specific stock, price action often rotates above and below an “average price.” This given price, or “point of control” when referring to volume profile, might be fairly stable, or could possibly be trending upward or downward. As this consolidation comes to what is referred to as a “balance,” price action will often tighten around this point of control. An example of this behavior is show below on the $BA daily chart:
This price action based on the point of control is typically what creates the formation of patterns that we see on our charts. Some may avoid such consolidation patterns, as they appear as sideways price action. However, couple this consolidation with other methods of technical analysis, and certain traders are able to determine whether said consolidation is a build-up situation to a large upcoming breakout of the stock price and option premium price.
Consolidation is a necessary part of the market today. Stocks don’t simply go up forever. Even the strongest moves need a breather (will see profit taking on the way up). These breathers, or periods of rest for the stock, are periods of consolidation. Despite consolidation patterns being created as a result of market indecision, the majority will resolve with a general agreement (up or down). Consolidation patterns typically evolve as average traders play the price action based on basic support and resistance zones of the stock. Technical traders will read this price action and being to anticipate price reversals, which may actually assist to decrease the range of highs and lows further as the pattern nears it’s conclusion. All of this eventually comes to a point where it becomes clear to experienced traders that the market will support a higher (or lower) price of the stock. This process is typically a price breakout followed by a sizable run up (or down), known as price discovery. Essentially, the market is looking for the next area to support the price of the stock, and therefore consolidate further. Below is an example using the $PZZA daily chart. Note the red horizontal lines as price levels being test by the market. Periods of consolidation, and therefore technical patterns, are indeed the precursor to the move from level to level.
Numerous consolidation patterns exist, each a little different. Just as with typical pattern trading, the first traders able to anticipate the next move of the pattern are often the most profitable. However, these same traders open themselves up to losses, as misreads will occur as to future price action. That being said, the more conservative traders will typically wait for the breakout, and may be one of the last to enter, seeing less profit as a result. In either case, set stops as the trade is made.
Technical analysis through pattern recognition, indicator signals, and candlestick signals can provide an advantage to knowledgeable traders, as technical analysis will provide signals of when to buy and sell.
This use of technical analysis during periods of consolidation can also help with the trade after price action breaks to the upside or downside. Based on chart patterns like an ascending triangle, one can measure from the high to low of the pattern using Fibonacci tools, and plan the their exit point based on extension levels as shown below on the $BABA daily chart:
This break to the upside or downside typically dictates future market direction, although reversals can occur. An effective method used commonly involves trading the breakout. Consolidation breakout traders tend to enter the trade on the breakout and ride the move to the next level of consolidation. This strategy can be applied to most any time frame.
Consolidation Energy Build
Imagine price action as a little bouncy ball that is limited by traditional support and resistance levels, in addition to fib levels, gann angles, linear levels, etc. The range of the price action would then be how high the ball bounces of falls. This rate of bounce or fall can be referred to in this example as simply “energy.”
As consolidation patterns form, this energy is limited, or capped by the levels around it. As a result, an energy build up is formed, waiting to be released. This release is the breakout. You will often see that in certain circumstances where this energy has been limited for a long period of time, or coiled up very tight, that the release of energy (or breakout) can be fast, powerful, and carry on longer before consolidating again. Catching this sort of move is likely a substantially profitable trade. These can be key times for options traders, as typically stocks in consolidation see their implied volatility decrease, therefore decreasing premium costs as well. Essentially, since the stock is trading sideways, premium costs are down on both sides, as the market is in an indecision. Once price breaks to either side, premium costs often begin to increase rapidly as price continues.
Inside bars are an easy and efficient way to find consolidation. Inside bars are essentially forms of consolidation that are simplified. They are a result of a symmetrical triangle (or coil up) of price action on a lower time frame than what is being viewed. As an example, an inside day typical represents a consolidation on the perhaps the 30 minute or hourly chart. Therefore, an inside day and up would be the result of an upside break of this lower time frame consolidation just as an inside day and down would represent a break to the downside.
Same chart, but on the 15 min. Here, we can see there was somewhat of a bull flag/falling wedge look, but price contraction still took place around the point of control prior to the breakout and run higher.
The consolidation stage can offer some of the best setups for traders in the market. Understanding the process and the end result can greatly help traders when navigating consolidating markets.
Pull up a daily chart of a few of your favorite names to trade and see if you can spot the periods of consolidation.
Hope the above information is helpful to you, and I wish you the best in your endeavors.