As a beginner to the stock market, it may be hard to recognise some market patterns and trends essential for technical analysis. If you are considering to get into trading, it’s important to learn important aspects like consolidation in the stock market to sharpen your trading skills.
This article will take you through the meaning of consolidation, how to identify a stock under consolidation and how to trade consolidations.
What is a consolidation?
Consolidation is a technical term used to describe a stock or security whose price is neither continuing nor reversing a larger trend. The price of consolidating stocks typically oscillates within a short range and offers a limited trading opportunity until the price of the assets rises above or falls below the oscillating price pattern.
This period is characterised by indecisiveness by traders.
A stock can be said to be a consolidating share when its price is stagnant or it is oscillating between two ranges for a prolonged period. Due to limited movement, there is usually low trading opportunity during stock market consolidation.
For example, if the shares of a company are fixed at $10 per unit for a long period or it’s fluctuating between $15 and $17 for a prolonged period, the share is consolidated during this period.
Since traders make profits through stock volatility or stock trending, it may be hard to make a profit during stock consolidation.
As a result, traders are always cautious of over-buying or over-selling during a consolidation period to prevent loss.
Here are the main attributes of a consolidating stock:
- Established resistance and support level
- No major trade spike
- A narrow trading range
What happens after a consolidation period?
Consolidation leads to a breakout. After a stock consolidation, there is either a continuation breakout or reversal breakout.
Traders may decide that the former trend was right and continue the breakout trend (continuation breakout ), or decide the initial breakout was wrong and start moving in the opposite direction of the breakout (reversal breakout).
To prevent loss due to a false breakout, traders need careful analysis to confirm a breakout before entering the trade.
Traders can utilise technical analysis instruments such as Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI) to confirm breakouts. The volume of the new trend can also accurately identify a true breakout.
What are consolidation patterns?
Consolidation patterns are technical analysis patterns that indicate movement of the price of a stock or asset within the same range. These patterns show continuation of the consolidation trend.
Traders observe consolidation patterns to know when the market trend may change and the direction of the change. Analysis of these patterns helps traders identify false and real breakouts.
Common technical analysis consolidation patterns include:
Ranges refer to highs and lows on the technical analysis chart that can be connected with a horizontal line. There is a range when the price of the consolidating stock swings up and down between two horizontal lines( the upper line represents the resistance while the lower line indicates the resistance).
A range can form when there is a trend movement sideways, upward or downward.
It is advisable to be cautious with range patterns. It often reveals false breakouts.
Symmetrical triangle is a consolidation pattern that emerges when the price movement generates two assembling trend lines with matching slopes.
A symmetrical triangle also indicates a period of price consolidation before a breakout or breakdown. The stock trades in the same range for a certain period. Increasingly slower stock trading over time will form a triangle on the chart.
Many day traders prefer to trade close to the tip or point of convergence of the triangle.
Ascending triangle is a consolidation pattern that is formed when you can draw a horizontal line toward the swing highs and a rising trend line towards the swing lows.
The ascending triangle can form when the resistance level did not break during the consolidation period. The support level gradually moves close to the resistance level until there is a breakout.
Descending triangle pattern can form when you connect a series of lower highs with a trend line and also connect a series of lows with another horizontal trend line.
The support level is constant while the resistant level decreases steadily until there is a point of convergence. The triangle indicates a breakdown of a consolidation pattern with a continuous negative trend until there is an eventual breakdown.
Rectangle consolidation pattern is also called flag pattern. The pattern either ends up in a breakout or breakdown.
A rectangular consolidation pattern is formed when the price is moving between two horizontal lines. Each horizontal resistance and support lines form the rectangle. The stock bounces off its resistance and support level in small trading ranges until there’s a breakout or breakdown of the previous trend.
How to trade consolidating stocks
Different forms of breakout can occur after a consolidation. There may be a bearish consolidation breakout or a bullish consolidation breakout. Your profit or loss will depend on your position.
However, you should be cautious of false breakouts as that can lead to monumental loss regardless of your position. To make a profit during a consolidation breakout, you should analyse the following factors:
The volume of trade indicates the strength of consolidation and a potential rise in price.
During the consolidation period, there is a low or flat level of trade. However, trades often pick up rapidly towards the end of the period, before a breakout. Look out for a consolidating stock gradually rising in volume to make more profit from its breakout.
Duration of the consolidation pattern
The longer the consolidation period is, the stronger the subsequent breakout. However, the longer the range, the higher the risk of a false breakout.
To prevent false breakout during long range consolidation, you shouldn’t rush to enter a trade. Wait for a while to get breakout confirmation.
Be wary of trade reset
Sometimes, prices may come back to a reset after an initial breakout. Although it might be tempting to enter the trade at the initial breakout, you may fall victim to a false breakout.
Be patient to wait out the initial breakout and confirm if there will be a reset period to avoid early adopter loss. Patience here is relative. At times the breakout might not be false. You may end up missing the breakout while waiting. It is your choice whether to take the risk or not.
While trade reset is not common in stock. It is not rare for the price of currencies to revert to consolidation price after an initial breakout in the forex market. Whether you are an FX or stock trader, you should be very careful in this regard.
A stop-loss order minimises trade loss. You should set a point of trade closure in case you fall victim to a false breakout.
You can make a loss or profit from a consolidation breakout. It all depends on careful analysis of consolidation trends and being wary of fake breakouts.
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