Market consolidation is a relatively popular concept in many financial markets, from stocks to cryptocurrencies to commodities. If you are considering day trading, understanding how consolidation works will help you make better trading decisions when the market inevitably changes.
We will explain how consolidation works and strategies you can leverage to trade it successfully.
- Stock consolidation is a technical analysis term referring to a situation where the price movement trades in limited price ranges.
- During consolidation, the direction of the price action cannot be clearly predicted. While there are fewer trading opportunities during consolidation, there are a few strategies you can leverage to trade it profitably.
For our context, consolidation is a technical analysis term referring to an asset that is neither reversing nor continuing a larger price trend. In other words, the asset’s price is trading within a given range, or trading sideways.
For example, if shares of Apple stock stay around the same price for several days or weeks, it can be interpreted as being in a consolidation phase. As you can see below, Apple’s stock price hovered around $147-$150 for several weeks until it finally broke past $150 and began trending upwards.
Generally, consolidation is a sign of market indecisiveness and caution. During this period, there are likely few trading opportunities that will be profitable until another pattern emerges or the range gets broken.
Why Does a Stock Consolidate?
Think of stock consolidation periods as reshuffling a deck of cards and dealing a new hand. When a trend movement dies down, buyers and sellers will take the opportunity to adjust their exposure to the market. If the price action is not as rewarding, investors and traders may sell their positions and exit. As buyers and sellers move in and out of the market, they set the stage for their next move.
Usually, consolidation happens after sharp price movements, such as a significant rally, as traders and investors try to absorb what caused the price action. For example, if there is news of a merger and acquisition deal, the stock price of the company getting acquired tends to rise while the stock of the company doing the merger will dip.
During an uptrend or downtrend in the stock market, there will be periods when the market moves sideways before moving back in the direction of the original trend. These consolidation periods are typically a result of professional traders and big institutions taking profits by selling their positions. Because these whales have large trading positions, they can stall the direction of the trend and take out all the opposite orders going into the market (typically from retailers like you and me).
Accumulation or Distribution
Accumulation and distribution occur when the market transitions into a new trend direction. During this time, institutional traders are likely buying positions in the opposite direction of the current trend until they build a big enough position to push the trend towards the direction they want, leading to a breakout.
An accumulation period usually follows a prolonged downtrend as institutional traders buy up major long positions to gear up for the next upwards trend. On the other hand, a distribution period follows a prolonged uptrend as institutional traders quietly offset their long positions and build up short positions to get ready for a downtrend.
Is Consolidation Bullish?
By itself, consolidation is neither bullish nor bearish for a stock. It is simply another stage in the market cycle. Usually, it may get followed by a continuation of the current trend or a reversal. A consolidation period can sometimes occur after a healthy price movement and allow traders to identify new trends to enter positions in.
Examples of Consolidation
A good example of consolidation is Pinterest. Back in October 2021, Paypal was in talks of acquiring Pinterest, which pushed the price of Pinterest to new highs following the acquisition news. However, when the deal fell through, the price of Pinterest quickly dropped, started consolidating, and then fell again.
At the same time, shares of Paypal stock tumbled after news of the acquisition before entering a consolidation period and then getting beat down more following a disappointing Q4.
Identifying Stocks Under Consolidation
To identify a stock that is consolidating, look for these 3 conditions:
- There are steady levels of support and resistance on the charts.
- There is a narrow trading range. Note that they may be relative to the stock as not all assets have similar volatility.
- There is relatively low volume, and the price action does not exhibit any major spikes.
Stock Consolidation Strategies
If you have been following the stock market for a while, you have probably noticed that the market frequently moves sideways. Since consolidation is a regular occurrence, it makes sense to use strategies to take advantage of these situations.
Before trading a consolidation, figure out how long the chart pattern has held for that stock. There are no time constraints on consolidation so they can last anywhere from minutes to weeks to months or even years. False breakouts may occur, so it’s crucial to look for confirmation first.
Price Consolidation: Support vs. Resistance
Think of support and resistance levels as the floor and ceiling for the price of a stock, with support being the floor and resistance being the ceiling. During consolidation, the security prices will move within support and resistance before breaking out in either direction.
Once the price breaks through these zones, volatility quickly increases, allowing traders to find profitable opportunities. If the price action breaks above resistance, that signals the price will keep going up, so traders will usually buy when this happens. But, if the price action breaks below support, that signals the price will keep falling, so traders will usually sell.
These levels are not static, so it is common for a support level to become a new resistance zone if there is a bearish breakout. Likewise, if there is a bullish breakout, the resistance level can form support.
After identifying a consolidation, another common strategy is to check for breakouts above the upper trading range bounds or breakdowns below the lower trading range bounds. A consolidation breakout or breakdown occurs when the price closes beyond the boundary of the consolidation patterns. When the candlestick wick moves above the resistance, it is a breakout, and when it moves below, it is a breakdown.
One way of thinking about this is lifting weights at the gym. When you are having a good day or feel strong momentum, you may end up lifting more weights than usual (breakout). But, when the pain becomes too much to bear, you have to drop the weights (breakdown).
A breakout happens when there is a bullish trend reversal. When that happens, the previous resistance level becomes new support. Breakouts usually get accompanied by a rise in volume, indicating more buyers than sellers in the market. They can lead to significant gains or losses in a short time, especially if there was a prolonged consolidation.
When the stock breaks out above resistance, the standard trading technique is to buy long and cover short positions. Some conservative traders may wait for confirmation through analytical tools or price action.
Similarly, a breakdown occurs when the breakout happens in a downwards direction. Usually, this results from the internal weakness of a stock as it lacks the strength to move up.
Ways to Anticipate Breakouts or Breakdowns
If you want to anticipate the direction of a consolidation pattern, there are a few key aspects to consider:
- A consolidation breakout or breakdown tends to occur in the same direction as the previous trend because it usually stays in place until there is a clear reversal.
- Some consolidation patterns are considered continuation patterns, so when you see these patterns, the breakout is likely to follow the direction of the previous trend. For example, triangles, tight ranges, flags, and pennants fall under this category.
- Volume analysis is crucial when trading breakouts. When trading volume exhibit major spikes as a breakout occurs, the price is likely to keep moving in that direction.
- Though false breakouts happen frequently, they can get used to figure out where the real breakout is heading. The real breakout usually happens on the opposite side after a false breakout, especially if it went against the previous trend. For example, if there is a false breakdown, the real breakout may move upward, and vice versa.
The Bottom Line
When stock prices are consolidating, finding profitable stock trades can be difficult. Still, there are strategies you can leverage to make money. Learning ways to identify and trade in consolidation will allow you to effectively manage your trading strategies and make money under various market conditions.