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How to Trade Consolidations

Sebencapital

Published
10/10/23
MOVING AVERAGE CONVERGENCE DIVERGENCE

Certainly, understanding and effectively Trade Consolidations or sideways markets is essential for traders. Consolidations can offer profitable opportunities when approached correctly.

Intro – What Is A Consolidation?

Consolidations occur when markets take a break. They can happen when a trend is progressing or just before a new trend begins. These consolidation periods come in different forms, like sideways ranges, wedges, double or triple tops, and triangles.

During a consolidation, the market is unsure about its next move, causing traders to ponder and plan. It's like a timeout where everyone gets ready for the next game. Big players often use pauses to enter or exit larger positions like major investors.

In simple terms, consolidations are like market pit stops, where traders refuel and make game plans before the next race begins.

Consolidation Patterns

We classify consolidation patterns into three main types:

  • Sideways ranges
  • Upward or downward-sloping ranges (known as flags)
  • Triangular consolidations (including triangles, wedges, and pennants)

Let's briefly examine these patterns before delving into how to trade them.

Ranges

A range is determined by connecting a price pattern's high and low points using horizontal lines. Price often remains in a range for extended periods, and understanding how to trade consolidations is a valuable skill for traders.

False breakouts and breakdowns frequently occur within horizontal ranges to discourage novice traders. The example below shows that the market moved sideways at the top, with fake breakouts at the bottom and the top. Therefore, waiting for a confirmed breakout is crucial when the price closes outside the range.

RANGES

Flags

Flags are consolidation patterns that emerge within existing trends, typically occurring between two trend waves. While inexperienced traders might confuse flag patterns as signs of a trend reversal, seasoned professionals patiently await a confirmed breakout to signal a continuation of the existing trend.

Flag patterns tend to be more dependable when the preceding trend wave before the flag's formation has been strong, increasing the likelihood of a trend continuation. A trend without these necessary consolidation phases often results in erratic behavior, making the trend unsustainable.

FLAGS

Pennants And Wedges (triangle Patterns)

When evaluating triangle patterns, the critical factor is the order of highs and lows and the relationship between the trendlines forming the upper and lower boundaries. For a more comprehensive understanding of how to trade triangles, we have a detailed guide exploring these nuances.

PENNANTS AND WEDGES

How To Trade Consolidations

When trading consolidations, three key concepts can enhance the profitability of your trades and reduce risk. One of the primary challenges in trading consolidations is avoiding false breakouts. The following three concepts are instrumental in identifying high-probability breakouts during consolidation periods.

1 – VOLUME ANALYSIS

Volume analysis can provide valuable insights into consolidations. While these cues might be subtle, they can reveal important information about what's occurring within the consolidation and offer hints about future movements. Typically, during a range, trading volume remains low and relatively stable. However, when the price approaches one end of the consolidation and volume increases, it can indicate a potential breakout.

In the screenshot below, you can see that each time the price broke out or was on the verge of breaking out to the upside, the trading volume showed an increase. Conversely, the volume was either low or decreasing when there was a fake or failed breakout.

Understanding these volume patterns can help traders distinguish between genuine and false breakouts, making volume analysis a valuable tool for consolidating trading.

VOLUME ANALYSIS

2 – THE HEIGHT AND WIDTH OF THE CONSOLIDATION

Consolidation is often compared to a pressure cooker, where pressure gradually builds up as someone holds down the lid. The longer the consolidation period and the narrower the consolidation boundaries, the more powerful the subsequent breakout is likely.

However, as the range lengthens, more traders will notice it. Longer ranges often experience more false breakouts as professional traders attempt to shake off amateur traders. During extended consolidations, the key to successful trading is patience. It's necessary to wait for a confirmed breakout and avoid entering the market prematurely by trying to predict a breakout.

THE LENGTH AND WIDTH OF THE CONSOLIDATION

3 – WAIT FOR THE RETEST

In Forex trading, the principle of retest-confirmation holds significant value. While stocks often exhibit runaway behavior after a breakout, currencies tend to return to the boundaries of the consolidation and retest those levels.

The USD/JPY chart below displays multiple large consolidation areas. Each time the price broke out of such a range, it retraced and retested the upper or lower boundary of the consolidation. Consequently, traders can trade the initial breakout, albeit with a higher chance of encountering false breakouts or waiting for the retest. This choice depends on the trader's preferences and the more natural style. There is no universally "better" or "worse" approach, as it varies from trader to trader.

For further reading, you can explore the topic of trading supply and demand zones.

WAIT FOR THE RETEST

Conclusion

Consolidations occur regularly and serve as a fundamental market structure during extended periods of trends or in anticipation of a new trend. Several factors and techniques can aid an observant trader in deciphering the dynamics within a consolidation, including volume analysis, the duration and range of the consolidation, the process of eliminating novice traders before breakouts, and the occurrences of failed breakouts. By piecing together these clues, skilled traders can make well-informed and sophisticated decisions about market sentiment within that consolidation.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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