Consolidation Patterns

Stocks & Commodities V. 8:11 (405-409): Consolidation Patterns by Melanie F. Bowman and Thom Hartle

Consolidation Patterns by Melanie F. Bowman and Thom Hartle

E

very price trend, be it stock or commodity, takes a breather from time to time. It is a period of

indecision when the pressures of buyers and sellers balance each other out. This stalemate most often sets in after prices have jetted upward or plummetted to the bottom of the chart. It is a sign that prices have moved too rapidly and the momentum has been completely absorbed by the prevailing supply or demand. This change from a trending (advancing or declining) to a consolidating market will usualy be accompanied by a visible increase in volume marking the beginning of the consolidation period. This increase in volume at the latter stage of a trend indicates that the price adjustment reflecting the opinions of traders and investors has reached a peak in either optimism or pessimism relating to the underlying fundamentals. The consolidation or more realistically labeled congestion period is a pause that allows participants to reevaluate the market and sets the stage for the next price move. Identifying such congestion areas and interpreting the evolving price action to determine the next direction provides tradeable opportunities. TRADING RANGE The classic congestion area is a trading range in which prices vacillate between a particular high and a particular low long enough for a chartist to draw horizontal lines through the tops and bottoms.

Article Text

Copyright (c) Technical Analysis Inc.

1

Stocks & Commodities V. 8:11 (405-409): Consolidation Patterns by Melanie F. Bowman and Thom Hartle

The classic congestion area is a trading range in which prices vacillate between a particular high and low long enough for a chartist to draw horizontal lines through the tops and bottoms. Although the high and low may differ only by a few dollars, the resulting trading range is evidence enough that buyers see the low price as a bargain and are eager to snap it up. At the same time, sellers see the high price as overvalued and are more than willing to sell. The typical bullish trading range begins with the price advance ending with a large volume day, representing a temporary buying peak (Figure 1, point A). This buying peak will be attended by positive news. As the good news has been discounted by the advance, however, a round of profit-taking will cause a decline in the market. This selling could be on light or heavy volume. The lighter volume is constructive evidence, as the lack of selling pressure indicates that large interests are still awaiting higher prices. An initial period of selling on heavy volume is not necessarily negative. Despite the initial occurrence of heavy selling due to profit-taking, the market could recover quickly once this period of profit-taking has concluded. Consequently, the very early price action after a buying peak may not give a clear signal as to the near-term direction. More price action is required to determine the outcome of the trading range. The boundaries of the trading in which prices vacillate between a particular range are difficult to estimate early on. Patience is required to allow the range to establish itself. After the first decline, typically, another assault on the recent highs is attempted. If the volume on this advance (Figure 1, point B) is weak, then the evidence points to lower prices, because the lack of volume indicates the higher prices are not attracting buyers. Without a sign of increasing demand, the market should fail to hold its gains. At this stage, it is likely that participants who did not sell the last time the market was in this price range will not let this second chance slip away. A decline in prices will unfold without a firm bid to the market. As this decline moves lower, a price that should attract buying will be reached. The buying will be made up of participants who believe that the price level reflects an undervalued situation. The demand, in turn, should be very strong. The evidence of demand is represented by the high volume and the close at the upper side of the range (Figure 1, point C). It would be even more favorable if the volume was larger on this minor advance compared with the day (point A) of profit taking that initiated the onset of the trading range, for this would indicate that the buying on the sidelines was stronger than the sellers. It is important to note that the market is a day-to-day trading affair. As each day's trading occurs, the relationship between the current price action and the past price action will continue to evolve. In Figure 1, the market is in an uptrend that deteriorates into a trading range at point A. When the decline reaches point C, the lower price level attracts demand that checks the decline by absorbing the available supply, and consequently, prices are marked higher. From this point, the best evidence of underlying strength would be if the market held the gains (point C) on quiet volume. The ability to hold the gains indicates that large participants are not waiting for the one-day rally to be concluded and are offering a large amount of supply at the better price created by the rise in the price. If large interests had wanted to liquidate their positions, the rise in price would provide the opportunity to sell.

Article Text

Copyright (c) Technical Analysis Inc.

2

Stocks & Commodities V. 8:11 (405-409): Consolidation Patterns by Melanie F. Bowman and Thom Hartle

When sideways price motion occurs amid a quick runup or decline, the trading range many times will adopt the form of a flag or a pennant. With this sign of demand and the indications of a lack of supply, market players are encouraged to reenter the market and bid prices up to a level to challenge the highs of the trading range (point D). Another expansion in volume should accompany this rally, especially as prices moved to new highs. After the upper limit of the trading range is penetrated, the market should hold onto the gains. The market should stabilize at this point, with the volume decreasing. This is another sign that the market is still held in control by bullish strong hands. If the technician understands the basic relationships between volume, price action and the trading range, other descriptive chart patterns that are variations of the basic trading range are also available. It is these chart patterns that provide insight into the flow of trading activity. FLAGS AND PENNANTS When sideways price motion occurs amid a quick runup or decline, the trading range many times will adopt the form of a flag or a pennant. It is as if the sideways movement is waving off the end of a flagpole drawn by the rapid increase or decrease in price (Figure 2). The lines connecting the tops and bottoms of a flag or pennant need not be horizontal like a trading range. These formations may tilt up or down. A flag's lines, however, are always close to parallel, while a pennant's lines converge. Because both formations result typically from quick price movements, they appear mostly on daily charts. It is rare to see a flag or pennant on weekly charts. The beauty of flag and pennant formations is that they usually mark the halfway point of a continuing price move. A pennant, in particular, is most often seen in the last phase of bull markets or bear markets. Typically, volume is extremely heavy before the flag or pennant appears and then backs off as the formation starts waving. This is an important clue about the trend. The volume surging in the direction of the trend confirms the underlying strength or weakness. The market then pauses on minor profit-taking (forming the flag or pennant) on light volume, and then when the price breaks out of the formation, the volume explodes. At this point, a trader can expect price to repeat the distance it traveled prior to the flag or pennant. HEAD AND SHOULDERS Head and shoulders are normally thought of as reversal patterns. The top or bottom reversal traditionally points in the direction of the original trend. Occasionally, however, when a head-and-shoulders formation flips and points in the direction opposite of the trend, it is a continuation pattern (Figures 3 and 4). For instance, when prices are moving up, the head and shoulders formation hangs upside down, representing a reaccumulation phase. Strong buyers are entering the market and accumulating positions in expectation of a continuation of the original trend.

Article Text

Copyright (c) Technical Analysis Inc.

3

Stocks & Commodities V. 8:11 (405-409): Consolidation Patterns by Melanie F. Bowman and Thom Hartle

During a bear market, the head and shoulders pattern represents a redistribution pattern (Figure 4). Unfortunately, the typically used price objectives of the head and shoulders pattern no longer hold up when it strikes the continuation pose. Price predictions are not reliable, and volume decreases from the left shoulder to the right. On breakout, volume can be expected to be relatively heavy, confirming the trend. During a bear market, the head and shoulders pattern represents a redistribution pattern (Figure 4). During this phase, the large players use the higher prices that occur during the countertrend move to sell holdings and position for a continuation of the downtrend. Although price objectives are not reliable in this mode, the formation serves as a good indicator that a reversal is not in the works. SYMMETRICAL TRIANGLES Unlike the pennants that occur during sharp daily moves, the symmetrical triangle appears regularly on charts of all time periods (Figure 5). As a bonus, it can be used to predict how far prices will continue after breaking out of the formation. Narrowing prices create the arrowhead shape of the symmetrical triangle, but unlike the implications of its name, the two sides of the triangle need not be at the same angle. It is only necessary that the two sides of the triangle slant to distinguish it from reversal triangles that have one horizontal side. As prices head toward the tip of the arrowhead, volume tends to diminish, evidence that the market is resting after the latest trend was completed. A trader expects price to break out of the formation about two thirds of the way to the tip, and with increased volume if the original trend was to the upside. Volume on a downside breakout is usually light and picks up after a few days. As with reversal triangles, the symmetrical triangle loses its significance if price exits through the tip of the arrowhead. A true breakout is a closing price beyond either slanted line at a distance equal to at least 5% of the greatest price distance within the formation. Melanie Bowman is a free-lance writer and former Managing Editor of STOCKS & COMMODITIES. Thom Hartle is STOCKS & COMMODITIES Technical Editor.

References Bowman, Melanie F., and Thom Hartle [1990]. "Reversal patterns", S TOCKS & COMMODITIES, October. Gartley, H.M. [1963]. Profits in the Stock Market, Lambert-Gann Publishing Co. Meyers, Thomas [1989]. The Technical Analysis Course , Probus Publishing. Pistolese, Clifford [ 1989]. Using Technical Analysis , Probus Publishing.

Figures

Copyright (c) Technical Analysis Inc.

4

Stocks & Commodities V. 8:11 (405-409): Consolidation Patterns by Melanie F. Bowman and Thom Hartle

FIGURE 1: In a trading range, price vacillates between support and resistance. When a low is reached that will attract significant demand (point C), prices are bid up to a level that breaks out of the trading range (point D), after which the market should stabilize with decreasing volume.

FIGURE 2: When sideways price motion occurs amid a quick runup or decline, the trading range may adopt the form of a flag or a pennant. Whereas a trading range's boundaries are horizontal, the boundary lines of a flag may slant and are always close to parallel while a pennant's boundary lines converge. Both formations typically appear on daily charts.

Figures

Copyright (c) Technical Analysis Inc.

5

Stocks & Commodities V. 8:11 (405-409): Consolidation Patterns by Melanie F. Bowman and Thom Hartle

FIGURE 3: Whereas the head and shoulders pattern traditionally points in the direction of the original trend, a continuation pattern forms when a head-and-shoulders formation flips and points in the direction opposite of the trend. When prices are moving up, the head-and-shoulders hangs upside down, representing a reaccumulation phase.

FIGURE 4: During a bear market, the head and shoulders pattern represents redistribution. During this phase, the large players use the higher prices to sell holdings and position for a continuation of the downtrend Although price objectives are not reliable in this mode, the formation serves as a good indicator that a reversal is not in the works.

Figures

Copyright (c) Technical Analysis Inc.

6

Stocks & Commodities V. 8:11 (405-409): Consolidation Patterns by Melanie F. Bowman and Thom Hartle

FIGURE 5: Narrowing prices create the arrowhead shape of the symmetrical triangle, but while reversal triangles have one horizontal side, the two sides of the symmetrical triangle slant. Price typically breaks out of the formation about two thirds of the way to the tip.

Figures

Copyright (c) Technical Analysis Inc.

7