Stock consolidation patterns can result in some strong breakouts. If traded correctly, they can result in some stellar profits when trading stocks and options.
When the market comes to an indecision regarding the value of a specific stock or financial instrument, price action often rotates above and below an “average price.” This given price (or “point of control” when referring to volume profile) might be reasonably stable or could be trending upward or downward. As this stock consolidation comes to a “balance,” price action will often tighten around this point of control, creating a coiling movement.
An example of this behavior is shown below on the BA daily chart:
This price action based on the point of control is typically what creates patterns that we see on our charts. Some may avoid such consolidation patterns, as they appear as sideways price action. However, pair this stock consolidation with other technical analysis methods, and certain traders can determine whether said consolidation is a build-up situation to a significant 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 or down forever. Even the most substantial moves need a breather.
These pauses, or periods of rest for the stock, are periods of consolidation. Despite consolidation patterns forming during market indecision, most will resolve with a general agreement (up or down). Consolidation patterns typically evolve as average traders play the price action based on the stock’s support and resistance zones. Technical traders will read this price action and begin to anticipate price reversals, which may actually assist in decreasing the range of highs and lows further as the pattern nears it’s conclusion.
Stock Consolidation Breakout
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. 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 stock price, 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 to losses, as misreads will occur as to future price action. 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 occurs.
Technical analysis through pattern recognition, indicator signals, and candlestick signals can provide an advantage to knowledgeable traders. Technical analysis will give signals on when to buy and sell depending on your approach.
This use of technical analysis during consolidation periods 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 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. A practical 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 consolidation level. You can apply this to most time frames.
Stock 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 price action range would then be how high the ball bounces or falls. This bounce or fall rate 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 forms, waiting to release. This release is the breakout. That 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 critical times for options traders, as typically stocks in consolidation see their implied volatility decrease, therefore decreasing premium costs. Essentially, since the stock is trading sideways, premium costs are down on both sides, as the market is indecisive. Once price breaks to either side, premium costs often increase rapidly as price continues.
Inside bars are an easy and efficient way to find consolidation. These are essentially forms of consolidation that are simplified. They result from a symmetrical triangle (or coil up) of price action on a lower time frame than what first meets the eye. As an example, an inside day typical represents consolidation on perhaps the 30 minute or hourly chart. Therefore, an inside/up day would result from an upside break just as an inside day/down would 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. However, price contraction still took place around the point of control before 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 significantly help traders when navigating consolidating markets.
To find these patterns in scans, use tools like Trade Ideas scanners to elevate your trading to the next level. One of my favorite scans on the Trade Ideas platform is “Out of Consolidation Up Big Today.”
Pull up a daily chart of a few of your favorite names to trade and see if you can spot the periods of consolidation. If you do, you might consider setting a few alerts to let you know when those consolidations break.
I hope you found this information to be helpful. If so, please share it with others.