Last Updated on 3 November, 2022 by Samuelsson
As with other aspects of life, there comes a time when the market pauses to take a breather by going sideways. In fact, markets spend a great amount of time going sideways (ranging), which traders refer to as periods consolidations. Knowing how to interpret and trade consolidations is an important skill in trading, but what exactly are consolidations in trading?
In trading, consolidation is a period when the price is moving sideways and not making any significant advancement in the upward or downward direction. During those periods, the price movement is restricted within a set of defined levels. A price consolidation implies a lack of trend and often signifies indecision among the market participants.
To help you understand consolidations better, we will discuss the topic under the following subheadings:
- What does consolidating mean?
- Understanding consolidation: why do consolidations occur?
- How to identify consolidation in stocks
- Is consolidation good for stocks?
- What is an example of consolidation?
- Other types of consolidation: the different consolidation patterns
- How do you trade consolidation?
What does consolidating mean?
In trading, consolidating means that the price of an asset is only moving sideways, without making any significant advancement in the upward or downward direction. When a stock is said to be consolidating, its price movement is restricted within defined levels, so there is a lack of trend. Consolidation is often considered by technical analysts and traders to mean indecision among the market participants.
Since consolidating stocks typically trade within limited price ranges, they offer relatively few trading opportunities until the price breaks out of the consolidation. The price, as you know moves in alternating cycles — uptrend, downtrend, and sideways — a consolidation may follow a downtrend or an uptrend.
It is important to know that consolidation can be a pause in an uptrend or downtrend, whereby the price would still resume in the direction of the trend. However, it can also be a transition period, signifying the end of one trend and the emergence of another. For example, it could be that the trend is changing from a downtrend to an uptrend or vice versa. To put it simply, a consolidation can be a trend continuation formation or a trend reversal formation.
Typically, when a stock is consolidating, its price movement stays within two established boundaries. These boundaries can take any shape and may be well-spaced or very narrow (tight consolidation), depending on the market volatility. If the swings within the consolidation boundaries are big enough, some traders may scalp it by going long at the lower boundary and getting out at the upper boundary. However, most consolidations are tight, so trading opportunities only arise when the price breaks out of the boundaries.
Understanding consolidation: why do consolidations occur?
You can see price consolidation on the chart of any timeframe, and depending on the timeframe, the period of consolidation can last for hours, days, weeks, or months. But why does the price of stocks or any other asset consolidate? Well, depending on where the consolidation occurs, it could either be as a result of profit taking or smart money accumulating or distributing their positions in readiness for the next trend.
Consolidation as a result of profit taking
In an uptrend or downtrend, there are periods when the market temporarily moves sideways in a tight consolidation before resuming again in the trend direction. Such consolidations are often caused by professional traders taking some of their profits off the table.
Because these professional traders, who trade for big institutions, command huge trading positions, when they send their take profit orders into the market, their orders will take out all the opposite orders (in the trend direction) coming into the market — often from the retail traders who still believe in the trend. As a result, the price movement in the trend direction stalls.
For example, a down-trending market may rally a bit and start moving sideways when the professional traders were taking profits. The opposite happens in an up-trending market. After the profit taking, the price continues in the same direction.
Consolidation due to accumulation or distribution
The period of accumulation or distribution is when the market transitions to a new trend. It is the time when institutional traders are busy building positions in the opposite direction, and when they have built enough position, they push the price in their desired direction, leading to a breakout.
The period of accumulation follows a prolonged downtrend. During this time, the big boys gradually build up huge long positions in readiness for the next uptrend. On the other hand, the distribution phase follows a prolonged uptrend because it 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 case, whether it is a consolidation that forms at the top of an uptrend or bottom of a downtrend, the period is marked by the price moving up and down within the established boundaries — support and resistance. The price will eventually break out and start a trend reversal.
How to identify consolidation in stocks
As with other financial assets, a stock can be in a consolidation period at any time. There are certain features you can use to identify a stock that is under consolidation. One of them is that the stock is trading with well-established support and resistance levels, which could give a rectangle, triangle, or wedge pattern.
Another important characteristic is that the trading range is narrow. However, this is not always the case, as not all stocks and securities have similar volatility — trading ranges are relative. The third feature is that there will be a relatively low level of trading volume that does not exhibit major spikes. All three features should be present at the same time.
Is consolidation good for stocks?
From our discussion so far, it is obvious that consolidation is just a stage of the market cycle, which may be followed up by the continuation of the trend or a trend reversal. So, on its own, a consolidation is neither good nor bad for a stock. A consolidation period can emerge after a healthy price movement and offer an opportunity for traders to enter new positions in the trend direction, but it can also serve as an accumulation or distribution phase in the market.
So, as a trader, you need to be careful when you notice a consolidation because the breakout can happen in any direction, even though it is biased in the direction of the trend prior to the consolidation. You may have to use other technical analysis methods, such as overbought or oversold situations and false breakouts, to support the direction to trade.
What is an example of consolidation?
A typical example of price consolidation is when the price is held in a tight range or what is called the rectangle pattern. Here, the price moves up and down between two horizontal boundaries — the upper boundary is the resistance zone, while the lower boundary is the support zone.
Depending on the size of the range, you may be able to scalp the price swings within the pattern in a lower timeframe. In this case, reversal candlestick patterns at the boundaries of the range may signal trading opportunities. You can trade the little swings until a breakout eventually occurs, at which point you switch to trade the breakout.
Trading the breakout of any of the boundaries
It does not matter how long the price stays in a range; it will eventually break out of one of the boundaries, which, for most traders, is the only way to trade price consolidations. Trading breakouts can be fun because of the momentum that comes with breakouts, but there are often false breakouts, which can lead to losses.
Other types of consolidation: the different consolidation patterns
Apart from the rectangle pattern, price consolidation can take any of the following forms:
- Wedges: Wedges are price consolidation patterns in which the price bars lie within two trend lines that are either 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 structures. There are two types: a rising wedge (where both trend lines are rising) and a falling wedge (when both trend lines are descending).
- Triangles: These are price consolidation structures that take the form of a triangle. There are three types of the triangle pattern: ascending triangle, descending triangle, and symmetrical triangle. 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. Both patterns are regarded as continuation patterns, so 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 also occur in the opposite direction.
- Flags and pennants: These are small price consolidation patterns that occur after a rapid price move in the trend direction. They are both continuation patterns, meaning that the price is more likely to continue in the trend direction. While flags are upward or downward sloping rectangular patterns, pennants are small triangles. When they occur in an uptrend, they are called bullish flags/pennants, and when they occur in a downtrend, they are called bearish flags/pennants.
- Double and triple tops/bottoms: Both the triple top/bottom and the double top/bottom patterns are price consolidations that occur after a prolonged uptrend/downtrend. Since they often represent a transition period from one trend to the opposite trend, these patterns are known as reversal chart patterns. They represent a period of accumulation or distribution, as the case may be, with a triple top or the double top pattern representing a distribution period, while a triple or double bottom pattern represents an accumulation period. While these patterns are seen as reversal consolidation patterns, the price can break out in any direction.
How do you trade consolidation?
As we stated earlier, if the gap between boundaries of the consolidation area is big enough, it may be possible to scalp the little swings in a lower timeframe as they bounce up and down between the boundaries. However, if the consolidation is quite tight, the only way to trade it is to trade the breakout.
Consolidation breakout/breakdown: what is it?
A consolidation breakout/breakdown is said to occur when the price closes beyond a boundary of the consolidation pattern — thus, a candlestick wick piercing through the boundary is not a breakout. If the upper boundary is involved, it is called a breakout, but if the lower boundary is involved, it is often called a breakdown. You can either enter a trade immediately it happens if the price has not sped away or wait for a retest of the breakout level.
No matter the consolidation pattern and the trend direction, the breakout can in either direction. So, you need to know how to predict the most likely direction of the breakout when trying to trade a consolidation pattern.
How to anticipate the breakout direction
To anticipate the direction of the breakout from a consolidation pattern, these are some of the factors to consider:
- The trend prior to the formation of the consolidation: A consolidation breakout is more likely to occur in the direction of the trend because the trend remains in place until it has clearly reversed.
- The type of consolidation pattern: Certain consolidation patterns, such as triangles, tight ranges, and flags/pennants are considered continuation patterns. When you see them, the breakout is likely to be in the direction of the preceding trend.
- Volume changes during the breakout: For stocks and other exchange-traded instruments where the trading volume can be determined, volume analysis is very vital in trading breakouts. An increase in trading volume when a breakout occurs shows that the price is likely to continue in that direction.
- The presence of a false breakout: While false breakouts happen a lot, they might give a clue as to the direction the real breakout will occur. Experience shows that the real breakout is likely to occur on the other side after a false breakout, especially if the false breakout is against the preceding trend. Hence, when there is a false breakout downward, the real breakout will likely be in the upward direction, and vice versa.