What Is Consolidation? And Why Does It Happen?

Personally, I swing trade stocks and I day trade futures. Consolidation breakouts are a big part of my stock trading strategy, and I use them quite often to confirm my futures trades.

A “breakout” play is simply a play in which consolidation is broken out of, and the trend continues on. These plays can be very profitable!

In short: Consolidation is a pause in a rally, or a sell off. Some, like myself, sometimes call it “chop.”

No matter what you call it, there are reasons for it. There is something going on within consolidation, and understanding what’s going on can benefit your trading.

Consolidation takes on many shapes and sizes. There’s bullish and bearish consolidation, and there’s flags, pennants and rising or falling wedges. They can be really wide, really thin, really long, or really short… there’s no set rule for size.

On a daily chart, consolidation can last weeks or months. On a 1 minute chart, consolidation can last for a few minutes, or it can last for a couple hours or more. There’s no rule for size or length of time.

As I mentioned, there are bullish and bearish consolidation patterns: bullish flags and bearish flags; bullish wedges (falling wedge) and bearish wedges (rising wedge); bullish pennants and bearish pennants. And that’s really all there is. Sure, each one can look a little different, but in general, these are your trending consolidation patterns. That is, they occur during a market that is trending one direction or the other.

There are, however, reversal consolidation patterns that occur when a trend exhausts. These patterns are part of distribution or accumulation (top of a trend or bottom of a trend, respectively). For example, a head n shoulders pattern is a type of consolidation that occurs at the top of a trend (distribution), and a cup n handle pattern occurs at the bottom of a trend (accumulation).

But this post is for trending consolidation, not reversal types of consolidation. There are two completely different reasons for both. So I’ll get back on track here with…

If the trend before the consolidation is up, then the consolidation is considered bullish. Vice versa for downtrends. These are considered bearish consolidation patterns. This is important to understand, because the likely direction for the break out will be in the preceding trend direction.

Note: ABSOLUTELY NOTHING IS GURANTEED IN THE STOCK, FUTURE OR FOREX MARKET!! So, just because it “should” break out in the trend direction, does not mean it will break out in the trend direction.

Also, it does not matter if you’re on a daily chart or a 1 minute chart. Consolidation is consolidation. Time frame has no bearing on anything. Just keep the time frame in context when deciding how far you can or can’t take a breakout trade, should you decide to enter one.

So, being able to spot consolidation and, understanding the likely breakout direction, is very important.

Now, let’s move on and discuss what’s happening in a trending consolidation pattern…

Everything from here on is based on my own studies of consolidation patterns, and what I learned from one of the best forex traders in the world. It all makes perfect sense. However, you should still ALWAYS do your own research and studies.

Anyway…. here’s the good stuff! Here’s the WHY it is happening. I love knowing the “WHY.”

So, whenever you see consolidation, it is most likely smart money building their position before the next leg up or down. They do this by taking advantage of retail trader psychology. Remember, you and I do not move a market; smart money does. Follow the smart money!

Retail traders (the “heard”) will get sucked into thoughts like, “I knew it! the trend is reversing.” Or, “It just can’t go higher. It’s gotta turn around.” This is a VERY bad habit to get into. Because, it certainly can go higher (or lower), and no, the trend might not be reversing.

NEVER think you know more than the chart knows. NEVER think you know something that someone else doesn’t know.

Moving on…

Smart money can build their position in consolidation by buying the dips within it (for an uptrend), or shorting the highs within it (for a downtrend). Remember, for every buyer there is a seller, and for every seller there is a buyer. While your selling your position because you think you know something nobody else knows, market makers (smart money) are buying. Let me show you what I’m talking about:

Smart money is taking advantage of retail trader psychology, and buying all the selling. It takes a buyer and a seller. Whichever one smart money is doing (buying or selling), is what I want to be doing.

Notice the breakout of consolidation in that pic? It was in the preceding trend direction. I played this particular breakout. It was a really good play! Probably would have continued on, but that drop you see afterwards was on September 3, when the whole market went crazy over some negative fundamentals. Which is also a good lesson: Things are constantly changing in the market. Fundamentals, in my opinion, drive technicals. Not the other way around. And fundamentals can change rapidly, therefore changing the technicals. Always be paying attention to everything.

Anyway, back on track here…

So smart money is building their position. That’s what, in my opinion, is happening in consolidation.

When their position is built, they continue on to their target price. This is the breakout. As I mentioned earlier, breakout plays can be very profitable. But again, just because a breakout “should” happen in the trend direction, does not mean it will happen in the trend direction. Here’s an example that just happened recently:

This was actually the chart I used to analyze the markets a couple days ago. In my analysis, I showed the 2 possible outcomes: one to the upside, and one to the downside. You can check it out here: What Will The Market Do This Week

I was aware that nothing is guaranteed, so I was prepared for a possible breakout to the upside. And, that’s exactly what it did. The fundamentals changed and became very bullish. Remember, in my opinion, fundamentals drive technicals, not the other way around.

Okie dokie! So now, hopefully, you have a better understanding of consolidation. It is important, because the market consolidates more than it trends. And breakout plays can be a lot of fun, and VERY profitable.

So now would be a good time to sit down in front of your computer, pull up your favorite platform, and start studying consolidation patterns on the charts.

Keep in mind the following:

  1. There is no rule to the size or length of consolidation
  2. There is no guarantee it breaks out in the direction of the trend
  3. Never assume anything. I assure you, you do NOT know something that smart money doesn’t know.

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