Last Updated on 29 June, 2022 by Samuelsson
While we often want the market to move in a clear direction with the right volatility, it, sometimes becomes choppy and congested, without any clear direction. Traders often like to avoid such markets, but there are many ways to apply market congestion in your trading. Before we go into that, let’s find out what congestion in trading means.
In trading, congestion is when the price is trading around a particular level without making any progress in any direction. Not only is the market moving sideways, but it does so in a haphazard manner, and often with high volatility, which renders the price action choppy. Although market congestions may not be tradable, congestion zones, however, can be put to good use because they represent areas in the charts that have seen much trading.
To understand the topic, we will discuss it under the following subheadings:
- What does congestion mean?
- How does congestion work in trading?
- When should you avoid trading?
- What does a choppy market mean?
- What should you not do in trading?
- Why does market congestion occur?
- How to use congestion zones to trade
What does congestion mean?
Congestion, in the financial trading world, is a market situation when the price is trading around a particular level without making any progress in any direction. When there is congestion, the market is not only is the market moving sideways but also moves in a haphazard manner, and often with high volatility, which renders the price action choppy.
In this market situation, the demand to buy the financial instrument is often matched by the seller’s supply, which results in the price not moving significantly and instead, maintaining a price action that looks congested. Congestion periods are marked by sideways price movement, showing the balance between buyers and sellers. However, the sideways movement does not have established upper and lower boundaries, as the price swings pretty randomly.
If you are doing chart analysis, you may see a prize zone where the price trades stay for an extended period of time. For instance, assuming a stock trades between $15.50 and $16.25 for several trading days, that price range can be said to be that stock’s congestion area. Since the price stays around that level for a long time, it shows that the area has relatively equal supply and demand.
Owing to the tussle between buyers and sellers at that level without a clear sign of a winner, most technical analysts advise retail traders against buying or selling at that level until the price breaks through the congestion area in one direction or another. However, while market congestions may not be tradable, congestion zones can be put to good use because they represent areas in the charts that have seen much trading.
How does congestion work in trading?
From our discussions so far, you can infer that congestion is a factor of supply and demand, which can influence the liquidity and trading price of a stock or any other financial instrument. Hence, congestion is a concept used by technical analysts and technical traders to describe a fierce tussle between bulls (buyers) and bears (sellers), as evidenced by indecisive price action.
As you may already know, technical analysis is based on many different theories, and one of them — the most popular one — is auction theory. According to the auction theory, there are a good number of buyers and sellers in the market at any given time, and the movement in the price of the asset depends on who is dominating between the buyers and sellers.
So, in a situation where the bulls are dominating, the asset (stock) price goes up since the buyers are willing to pay a higher price. On the other hand, if bears are dominating, the stock price goes down since sellers sell at a lower price. However, when there is a relative equilibrium in the balance of supply and demand, then the price will stay at that level without making much progress. That level or price zone is referred to as an area of congestion by technical analysts because the price is moving sideways and staying congested at one level.
In summary, the main features of price congestion are as follows:
- Market congestion occurs when the price is trading around a specific price zone for a long time because bulls and bears are of equal strength.
- Congestion happens because there is no new news about the asset, so buyers and sellers are in equilibrium.
- Congestion can occur before a major news announcement as traders await the news or after a big price movement when traders may be digesting the big move to know what to do next.
- Market congestion often ends when either the bulls or the bears overpower the other and the price moves out of the congestion price range — typically on high volume.
When should you avoid trading?
Most technical analysts advise retail traders against buying or selling at that level until the price breaks through the congestion area in one direction or another. The usual reason is that the tussle between buyers and sellers at that level does not allow one to know who is dominating the market, and where the market is likely headed.
Furthermore, the situation is even worse if there is high volatility, with the price spiking up and down without any significant push in any direction. In such a situation, your trades can easily get spiked out as fast as you place them.
So, it is not every market condition that you should trade. Knowing when you should avoid trading is very important to protect your trading capital for the times when the market conditions are favorable. You should avoid trading when there’s market congestion so that you don’t get whipped by spikes.
What does a choppy market mean?
The term, “choppy market” is used to describe a market condition where the price frequently spikes up and down for a considerable period of time. The price spikes often happen around a specific price zone and are usually associated with periods of high volatility. As we stated earlier, choppiness is one of the hallmarks of market congestion periods.
A choppy market indicates that buyers and sellers are in balance, despite their fierce fight. The price is moving up and down, slowly or quickly, in large moves or small moves, but it isn’t making headway higher or lower overall. So, there isn’t an overall winner between the bulls and the bears. You can see this sort of price action after the release of news data that the market is trying to figure out what the impact would be.
Why does market congestion occur?
There are many reasons why congestion happens in trading, but they all manifest via the same mechanism: a balance in the activities of different market players. For example, congestion can occur when there is no significant news or information concerning an asset, as buyers and sellers will be relatively balanced, thereby keeping the price relatively stable.
On the other hand, congestion can also happen before a major news announcement since most investors and traders are waiting for the news; as a result, the price may not be moving much. For example, if you have been trading stocks, you will notice that a stock normally trades in a tight congestion before a highly anticipated earnings report, and when the earnings are released, the price is likely to break out of the congestion area with speed. Sometimes, if investors are finding it difficult to make sense out of the report, the price action may be choppy, spiking up and down.
It is also normal for congestion to happen during periods of indecision, such as during lunchtime. In that case, you may notice the price shoot up and then start moving sideways. The sideways period shows that traders are not actively pushing the price in any particular direction as they may be reassessing the outlook of the asset and digesting their trades for the day. As a result, this type of congestion is often short-lived as market activity picks up after lunch when traders come back to their trading desks to resume trading.
How to use congestion zones to trade
While you are not advised to trade market congestions, there are many ways congestion zones can be very useful to your trading. We will try to discuss three of them here, and they are as follows:
- Congestion zones as support and resistance
- Congestion zones for trade exits
- Congestion zone as warning zone
Congestion zones as support and resistance
Congestion zones can serve as solid support and resistance levels, which are much better than what most traders use to identify import price levels. For example, many traders use swing points to estimate support and resistance levels, while some use the pivot point formula and Fibonacci projections for the same purpose. While these are great methods, they cannot be as good as congestion zones, because, just like volume profile, congestion zones indicate where the price has stayed for a longer time.
As a trader, you should not overlook congestion areas; they can become solid support and resistance zones that are highly reliable. What you should do is to map out the area of congestion with two horizontal lines — you may shade the space in-between if you want. Expect a price reaction at that zone anytime the price reaches there.
Congestion zones for trade exits
Another huge benefit of congestion in trading is that it can tell you that it’s time to exit the market. Experience has shown that most trends do not reverse sharply, but instead, tend to drift sideways before resuming or reversing. So, whenever you managed to join a trend early enough and secure some floating profit, you may use signs of price congestion to take some of your profits off the table.
Those signs of congestion are like the road signs that tell you when it is time to book some nice profits and convert them from paper profits to real profit before the trend resumes or reverses. Aside from using present signs of congestion to exit from a trade, previous congestion zones can be a reference for stop loss and profit targets.
Furthermore, day traders tend to combine congestion patterns with the time of the day for effective exits. For example, seeing congestion signs at midday or towards the end of the trading session would be a strong indication for immediate exit.
Congestion zone as warning zone
Aside from the other benefits, price congestion can warn you about the prospects of a particular market. If a market stays in congestion for a prolonged period, it can be a warning that the profit potential in that market is limited. So, it is better to stay out of that market until the market breaks out from the congestion area.
Of course, it makes no sense to put your trading capital at risk the profit potential in the market is limited. While you may want to try to anticipate the eventual break-out, you should know that there can be multiple false breakouts. So, not trading at all until there is a reliable breakout, with obvious signs of trend continuation, is always the best way to go about it.
What should you not do in trading?
Trading is one of the most risky businesses you can get into, so you have to be very careful to avoid losing your shirt. As a trader, there are things you should not do, and these are some of them:
- Trading a market congestion: It is preferable to avoid trading a market congestion because of the risk of being spiked out of position. Nonetheless, you can use congestion zones as a reference point for your stop loss orders.
- Trading without a stop loss: Risk management is the key to successful trading. Without it, you will end up blowing your account. You should never place a trade without a stop loss order.
- Trading without a plan: It is essential to have a trading plan and stick to it. Randomly jumping into a trade and hoping that the market would move in your favor is a recipe for failure.