Consolidations are basically sideways or slow trending movements in price that stay relatively flat over a period of time. This is caused by the close proximity to order-flow between buyers and sellers. This creates a Channel whereby traders, who recognize it, eventually begin to take a position on the side of the breach.
Consolidations demand the use of relatively tight stops, thus removing the risk of a large loss if the breach fails to follow in the given direction. For example, once a price has broken out of the consolidation, you can either set your stop just to the other side of the breached line or in the middle of the consolidation if you choose to leave more room. This of course depends on the size of the consolidation, as some can be quite large.
When monitoring for a breach in a consolidation pattern, it is also important to see that a rise in volume accompanies the move. This is an indication of strength and is normally required to see a trend continuation. Although this tends to hold as a better rule for long positions than it is for short positions, but higher volume is always preferable regardless of the breakout direction.
Consolidations come in several forms. Flags/Pennants, Rectangles/Wedges, and Triangles are just a few. Depending on where your studies originate, people may debate the actual name of a consolidation formation but it really does not matter. The name of the game is to identify and initiate a solid trade from it.
The Falling Wedge leads price lower. However, this pattern is regarded as bullish once the upper trending price line is breached. As you can see on this chart, the slow fading consolidation lasted nearly four months before the breakout triggered.
The Rectangle is probably one of the most common patterns to identify and to draw. It simply has two lines, both with at least two points of support and resistance that are sliding sideways. Once one of the price lines is broken we look for direction into this area and use the given line as either support or resistance on the trade, depending on the direction of the breach.
The Flag/Pennant is used to identify a relatively small consolidation before the previous trend resumes. Look for a sharp advance or decline in volume where these form. They often can be used as the mid point of the total move.
As an example, and we cannot show it all on this chart because of space, but GLD made a strong break higher from the $60.00 area into an $80.00 Flag. This was roughly a +20 point advance. Add that to the top of the Flag and we have a new target of $100.00. A secondary Flag built along the trek higher and is shown at the $90.00 area. The original $100.00 hit and eventually pulled back over the next several sessions. These formations build under Supply/Sell and Demand/Buy pressure and are excellent to search for on a shorter term basis.
The important thing to remember is that once a consolidation forms, it's breach will usually occur into the direction of the trend that was there before the consolidation began. Nothing works 100% of the time, so be sure to use Stop-Loss Orders.
