It doesn’t matter the asset you trade, most markets spend an appreciable amount of time to consolidate after trending upward or downward. As a trader, it is important to know how to identify and interpret consolidations to know if you should stay out of the markets when you spot them and wait for breakouts or find ways to make some quick trades within the consolidation.
Trading when the market is consolidating is very difficult and can be highly frustrating as the price frequently moves up and down, creating lots of false signals. To trade during such a condition, you need to have a strategy that is suitable for that market situation so that you get in fast at one end and get out at the other.
But since the price will eventually break out of the consolidation, the popular choice among forex and stock traders is to wait for the price to break out of the consolidation. But knowing when and which direction the breakout can be quite difficult
In this post, you will learn:
- What consolidation is
- Why consolidations occur
- The different consolidation patterns and how to trade them
- How to anticipate the breakout direction
- How to assess the potential of a consolidation breakout trade
Trading consolidations: what is price consolidation?
A price consolidation is a period when the price is moving sideways without any significant advancement in the upward or downward direction. It shows a lack of trend and often signifies indecision among the market participants. As the price moves in alternating cycles, a consolidation often follows a downtrend or an uptrend.
Thus, it can be a temporary break in an uptrend or downtrend, whereby the price would still resume in the direction of the trend. On the other hand, it can also be a transition period where the trend changes direction — from downtrend to uptrend or from an uptrend to downtrend. In other words, consolidation can be a trend continuation formation or a trend reversal formation.
Typically, when there is a consolidation, the price moves within two established boundaries, which could be significantly well-spaced or very narrow (tight consolidation), depending on the volatility in the market. The upper boundary marks the resistance zone, while the lower boundary is the support zone.
It is possible to trade the price swings within the boundaries if they are big enough for a meaningful profit — take long positions around the support zone and short positions around the resistance zone. However, tight consolidations are difficult to trade as the price barely swings up and down within a narrow range — with the price bars almost standing side by side. Whatever is the case, a consolidation draws to a close when the price breaks above the resistance zone or below the support zone.A price consolidation can take any form. It could be a rectangular pattern (often called a range), any of the different types of triangle patterns, a rising or falling wedge, a pennant, or a flag. Whatever the pattern is, there is a reduced market activity, which in an exchange-traded product like stocks, can be observed by the decline in trading volume. When the price finally breaks out of the trading consolidation, there is often an increase in volume.
In the forex market and other OTC financial instruments, you don’t have a centralized volume data, so it is difficult to use volume to analyze a consolidation and the subsequent breakout that occurs.
Why do consolidations occur?
Depending on where the consolidation occurs, the primary reason for the price formation can be either of these two:
- The big traders are taking some profits off the table
- They are accumulating or distributing their positions in preparation of a trend reversal
Profit taking by professional traders
A consolidation that happens within an uptrend or a downtrend is often caused by professional traders taking some of their profits off the table. Since these institutional traders command huge trading positions, when they send their take profit orders into the market, the orders will take out all the opposite orders (in the trend direction) coming into the market from the retail traders who still believe in the trend.
That is, if the market was in a downtrend when the professional traders were taking some profits off the market, retail traders were still selling, but the take profit orders from the institutional traders were able to consume all the retail orders to force the price up, stalling the downward move. The opposite happens in the case of an uptrend.
Accumulation or distribution
During periods of accumulation and distribution, the market is transitioning to a new trend, and institutional traders are busy building positions in the opposite direction. The period of accumulation happens after a prolonged downtrend; it is the time when the big boys gradually build up huge long positions in readiness for the next uptrend.
Occurring after a prolonged uptrend, the distribution phase is a time when the big boys are quietly and gradually offsetting their long positions and building short positions in preparation for a downtrend.
Whatever the type of trend reversal trading consolidation, the period is marked by the price moving up and down within the established boundaries — support and resistance. Eventually, the price will break out in the opposite direction to start a new trend.
Trading consolidations: types of consolidation patterns and how to trade them
There are various types of consolidation patterns. Here, we will discuss some of them — one after the other — and how to trade each of them.
Range
Also known as the rectangle pattern, a range market is one in which the price swings up and down between two horizontal boundaries. The upper boundary is the resistance zone, while the lower boundary is the support zone. The price tends to swing between the two boundaries until it finally breaks out of the range to start a new trend or resume the pre-existing trend.
Thus, the pattern represents either a pause in a trending market or a transition period before a trend reversal. With the price being restricted within the boundaries of the range, there is a relative balance in buying and selling pressure (demand and supply).
Depending on the size of the range, you can trade the price swings within the pattern until a breakout occurs; then, you trade the breakout.
Trading the price swings within the pattern
If the size of the range is big enough to offer tangible profit, you can trade the individual up and down price swings within the range. Around the upper boundary of the range, look for shorting opportunities. A bearish pin bar, engulfing bar, or inside bar can be a trade trigger. Alternatively, you can use a bearish divergence signal in an oscillator.
Around the lower boundary, look to go long if you see a bullish candlestick pattern, such as a bullish pin bar, inside bar, or engulfing bar. You may also use a bullish divergence signal in an oscillator, such as stochastic or RSI.
See the AUDUSD chart below; it shows a range with sizeable price swings. You can see the bearish pin bar and inside bar setups (shorting opportunities) that occurred at the upper boundary and the bullish pin bar setup (buying opportunity) that occurred at the lower boundary. The bullish setup also coincided with a bullish divergence in the stochastic. Note the positions of the stop loss (SL) and take profit (TP).
Trading the breakout of any of the boundaries
No matter how long the price stays in a range, it will eventually break out of one of the boundaries. For most traders, trading the breakout is the only way to trade price consolidations. While trading breakouts can be fun because of the momentum associated with them, you may get many false breakouts before getting a real one.
By definition, a breakout happens when the price closes beyond the boundary — a candlestick wick piercing through the boundary is not a breakout. When a breakout happens, you can either enter a trade immediately if the price has not sped away or wait for a retest of the breakout level.
Below is the same AUDUSD chart when the price broke below the lower boundary. Note the entry level, stop loss position, and potential profit target.
Wedges
Wedges are price consolidation patterns in which the price bars lie within two trend lines that are sloping upward or downward but with one trend line having a greater slope than the other. Since the boundaries will eventually cross each other, the price swings within the boundaries of the pattern keep getting smaller and smaller over time, until the price breaks out of any of the structure, which presents the only tradable opportunity with this pattern.
When the trend lines are sloping upward, with the lower trend line having a greater slope, the pattern is called a rising wedge. On the other hand, when the trend lines are sloping downwards, with the upper trend line having a greater slope, the pattern is called a falling wedge.
A rising wedge has a bearish effect, and depending on where it occurs, it can be a bearish trend reversal pattern or a bearish trend continuation pattern. If it occurs in an uptrend — slowly rising swing highs and rapidly rising swing lows — it can bring a trend reversal. When it occurs as a pullback in a downtrend, it indicates the continuation of the downtrend. So, the price breaking below the lower boundary is an indication to go short.
The AUDUSD chart below shows a rising wedge consolidation pattern that became a transition from an uptrend to a downtrend. Note the possible position of a stop loss order if you’re to trade the pattern.
In this chart below, a rising wedge consolidation was a pullback in a downtrend. When the price broke below the lower boundary, the downtrend continued.
A falling wedge (slowly descending swing lows and rapidly descending swing highs — is bullish by nature, irrespective of where it occurs. When it occurs in a downtrend, it signals a potential trend reversal. If it occurs as a prolonged pullback in an uptrend, it indicates the continuation of the uptrend. So, when the price breaks above the upper boundary of the pattern, it is a signal to go long.
As you can see in the GBPAUD chart below, a falling wedge consolidation was formed as a pullback during an uptrend. When the price broke out of the upper boundary, the uptrend continued.
Triangles
These are price consolidation structures that resemble one form of a triangle or another. As with the wedge pattern, the price swings within the boundaries of the pattern keep getting smaller until the price breaks out of any of the boundaries. It is, therefore, difficult to trade the individual swings within the pattern, so you should only look for breakout trades.
There are three types of the triangle pattern: ascending triangle, descending triangle, and symmetrical triangle. In the ascending triangle, the swing highs are at the same level, giving it a horizontal upper boundary (resistance level), while the swing lows are rising, giving it an upward-sloping lower boundary (support level).
The descending triangle has a horizontal lower boundary (support level) and a descending upper boundary (resistance level), which means that the swing lows are around the same level while the swing highs are descending. For the symmetrical triangle, the upper boundary is descending, while the lower boundary is ascending — this means that the swing highs are descending, while the swing lows are ascending.
Regarded as continuation patterns, the price is more likely to break out in the direction of the trend preceding the formation of the triangle pattern. However, a breakout can occur in either direction.
In this USDJPY chart below, the price was in an uptrend, and two triangle consolidation patterns occurred. The first one was in a symmetrical triangle, while the second was a descending triangle. In both cases, the price broke to the upside, in line with the pre-existing trend.
Flags
Flags are small price consolidation patterns that occur after a rapid price move in the trend direction. They are upward or downward sloping ranges, with the price bars lying within two parallel lines hanging off a rapid price swing. Flags are continuation patterns, meaning that the price is more likely to continue in the trend direction.
In an uptrend, the two parallel lines are either horizontal or slope downward, and the pattern is called a bullish flag. A trade setup occurs when the price breaks above the upper boundary to continue the uptrend, as you can see in the AUDUSD chart below.
For a down-trending market, the parallel lines that form the boundaries of the pattern can slope upward or stay horizontal, and the pattern is called a bearish flag. A bearish trade setup occurs when the price breaks below the lower boundary to continue with the downtrend. See the AUDUSD chart below. Note the positions of the stop loss and profit target.
Pennants
These are similar to the flag pattern, in that they are short consolidation patterns that occur after a rapid price swing in the trend direction. However, pennants are triangular in shape. They are continuation patterns that occur as small symmetrical triangles after rapid price movements.
When the pattern occurs in an uptrend, it is called a bullish pennant, and a breakout of the upper boundary is a signal to go long. The gold chart below shows a beautiful bullish pennant. Take note of the position of the stop loss and profit target.
A pennant that occurs in a downtrend is called a bearish pennant, and the breakout of the lower boundary of the pattern is an indication to go short, as you can see in the AUDUSD chart below.
Triple top/bottom
Both the triple top/bottom and the head and shoulder patterns are price consolidations that occur after a prolonged trend and often represent a transition period from one trend to the opposite trend. They represent a period of accumulation or distribution, as the case may be.
A triple top or head and shoulder pattern represents a distribution period, while a triple bottom or an inverse head and shoulder pattern represents an accumulation period. Thus, these patterns are known as reversal chart patterns.
Using the triple top/bottom pattern as an example, it has an upper resistance level and a lower support level. In the triple top pattern, the support level is the neckline. When the price breaks below it, a new downtrend is believed to emerge, so it makes sense to go short.
The GBPJPY chart below shows a triple top consolidation pattern, which was a transition from an uptrend to a downtrend. The breakdown of the neckline marked the beginning of the downtrend.
For the triple bottom pattern, the resistance level is known as the neckline, and when the price breaks above it, a new uptrend may be emerging. So, you can look to go long. The Momenta Pharmaceuticals Inc. chart below shows a triple bottom consolidation pattern serving as an accumulation period before a new uptrend emerged.
Mind you, these patterns are not cast in stone; they can and do fail. In a triple top situation, the price can still break above the resistance level and continue trending upward. Similarly, in a triple bottom pattern, the price can still break below the support level and continue the downtrend.
Trading consolidations: how to anticipate the breakout direction
It is not easy to know, for sure the direction the price will breakout after the consolidation, as it is difficult to tell whether the trading consolidation is a trend continuation formation or a trend reversal formation. Unfortunately, if you get your analysis wrong, you are likely to get caught in false breakouts. However, the following can help you assess the most likely direction of the effective price breakout.
The preceding trend
As the saying goes, “The trend is your friend.” So, it is preferable to look for a true breakout in the direction of the trend preceding the consolidation. In this case, we are assuming that the consolidation is a continuation formation, especially if it is a pattern like a triangle, pennant, flag, a falling wedge in an uptrend, or a rising wedge in a downtrend, which are believed to be continuation patterns.
The chart below shows a tight range that occurred in an uptrend, and it looks like a bullish flag. Expectedly, the price broke to the upside to continue the uptrend. Note the false breakout to the downside that occurred earlier.
However, there are situations when the consolidation may be a transition phase for a trend reversal, in which case, it is best to look for a breakout in the opposite direction. But it is difficult to known when trading consolidation is a preparation for a trend reversal unless you’re dealing with a possible trend reversal chart pattern like triple top/bottom or head and shoulder.
False breakout
One common thing about consolidation breakouts is that false breakouts happen a lot. But the good thing is that a false breakout might give a clue as to the direction the real breakout will occur. The real breakout is likely to occur on the opposite end of a false breakout. Thus, if there is a false breakout downward, there is a higher chance that the real breakout will be in the upward direction, and vice versa.
In the GBPUSD chart below, a false breakout occurred to the upside and, later, the real breakout occurred to the downside.
Volume analysis
When trading a consolidation breakout, volume analysis may be very helpful if you are dealing with an asset that is traded on an exchange, such as stocks and futures, which have central volume data. Volume analysis can tell you about the level of activity in the market. Normally, the volume is reduced during a consolidation, but increases when a breakout occurs. If a breakout occurs with a reduction in volume, the breakout is more likely to fail, but if it occurs with an increasing volume, there is a higher chance that it will work.
Take a look at the Bruker Corporation chart below. Volume, which had been near flat all through the triple top consolidation, started increasing as the price broke the neckline of the pattern.
Trading consolidations: how to assess the potential of a consolidation breakout trade
These are some of the factors to consider when trading a consolidation breakout:
- The tightness and duration of the consolidation
- A successful retest of the breakout level
The tightness and duration of the consolidation
Consolidations are like compression springs — the longer and stronger you compress it, the more violent it will expand when it is eventually released. The tighter a consolidation is and the longer the period of consolidation, the larger the price movement after a breakout.
A successful retest of the breakout level
If, after a breakout, the price successfully retests the breakout level and continues moving in the expected direction, the breakout is in good shape. But if the price falls back into the consolidation zone, the breakout might have been a false one. In fact, some traders prefer to enter a trade only after the breakout level has been successfully retested.
In the chart below, you can see that the price came back to retest the neckline. Note the bullish pin bar hanging on the neckline, which makes for a perfect trade entry.
While this may reduce the likelihood of getting caught up in a false breakout, it will certainly lead to missing a lot of trades since the price doesn’t always come back to retest the breakout level.
Final words
Trading consolidations are periods when the price moves sideways, showing a lack of trend. It signifies indecision among the market participants and often manifests as various chart formations, such as rectangular range, triangle patterns, wedges, flags, pennants, and others. While you may be able to trade the individual swings within the consolidation if it is big enough, the ultimate way to trade consolidations is by trading the breakouts.