This week I thought we could look at consolidation, what it means and where it takes place.
I regularly use the term consolidation - "price has come back to consolidate", "price may need to consolidate the recent gains", "the consolidation process has begun" etc. So below is my interpretation of this term and what is actually taking place, including some examples.
When price rises substantially it is quite normal for this rise to eventually draw out increased supply (selling).
This increased selling pressure comes from profit takers who have bought at a lower price, old stale holders who have been holding at a loss, and can now 'get out' of a poor position, and new short positions opened for various reasons (usually for profit, hedging or strategy).
The rise in price can be a single bar or multi bar breakout from a sideways trading range or accumulation zone, or it can be in an uptrending market. Either way, at some point enough supply is drawn out that thwarts ease of movement higher, and in response price will usually attempt to deal with this difficulty, by pulling back a little in an effort to absorb (buy) the supply which has been drawn out. It is this (shallow) pull back that is the 'consolidation'.
In a perfect world the consolidation process would see price come back with reducing spreads and volume, and is considered successful if price then accelerates away and moves higher than the previous high.
The spread or range of the bar is closely aligned with volatility, so narrowing spreads illustrate reduced volatility.
The reducing volumes show that the selling pressure which was drawn out from the rise in price, has eased.
The pull back can be down to the lows of the initial rise in price, so if it is a single upbar that breaks out, price can legitimately come all the way back to the low of this bar before it is vulnerable to failure (yes, the consolidation process can fail if supply does not ease, and it eventually overwhelms demand and causes a price breakdown). If it is a multi bar breakout, use the lows of the first bar as the line in the sand, and in an uptrending market, it is back to the last minor pivot (see below).
When considering these periods of consolidation I always like to see a quite shallow pullback, as to me it suggests that price is quite strong. I prefer to see a consolidation push no deeper than 50% of the up range for this reason.
Finally, bull flags and pennants when using classical technical analysis are the consolidation process in action, and you will easily be able to picture these patterns in some of the examples below.
How far can price pull back before it is vulnerable to failure.
A textbook view of the consolidation process after a two bar breakout from an accumulation zone, and some notes.
Remember it is just the little pullback after the breakout, that is the consolidation (of the gains).
