Today we are going to study consolidations in more detail.
Consolidations are the basis for most swing, day, and momentum energy moves. It is therefore important to recognize the difference between a strong consolidation, a weak consolidation, and a tiny run that may look like a consolidation but is actually not one.
In this discussion, we are going to study a consolidation that stepped down then formed a long white candle. These patterns are often “gottcha’s” for retail traders who assume a downtrend or sell short opportunity is present when in actuality, other factors are causing the mild retracement.
EME on the chart below has a solid consolidation for the past 4 days. It ran up with 2 gaps and settled in to consolidate just below the previous short term highs in mid October.
Chart 1This pattern is called a “resting phase” which means the stock is resting after moving up quickly.
Stocks that rest rather than retrace immediately often have strong energy behind them.
Often these patterns form during quiet accumulation periods with large lot institutional investors or traders.
The consolidation is nice and horizontal without any up or down action that would be a tiny run. It is building energy. Green Volume bars are stronger than the red volume bars.
Yet the next day it forms a broken step, with a surge of red volume or downside volume. Novice traders using the broken step sell short entry signal would immediately jump into a sell short position because they are not studying all of the areas of the chart that need to be analyzed.
Chart 2The next day the stock moves down a small amount and the sell short trader is excited that they are in a good selling down trade.
Chart 3Then comes the “gottcha” the next day. A big white not only wipes out scant sell side profits, it nets the trader a loss on the trade.
Chart 4So what went wrong? Why was the sell signal and volume not enough to determine a sell short trade?
First, you have 2 common gaps on the initial run up prior to the resting phase consolidation. Those gaps are common, common gaps fill easily. So the move down was mostly a fill the gap scenario NOT a shift of sentiment.
Buyers, big lot buyers had been moving into the stock at the gap level. So as the stock dropped to their bracketed controlled entry price range, their orders were automatically triggered and the stock ran up that day.
Notice that the white candle remains contained within the original range between the low of the gap and the high of the consolidation. This is large lot activity triggered by their price range being hit.
We often see a good setup with a resting phase consolidation that then turns down weakly for a day or two only to move right back up.
This is because in these resting phases of consolidations, the buy side is usually in control. We have seen many of these patterns of late and too often retail traders are caught on the wrong side of the trade, selling short, OR they panic after buying into the stock, sell in panic, and then watch the stock recover as soon as they are out of the trade.
Trading profitably takes more than an indicator crossover, or buy signal, you need to really study what has occurred recently and take that into consideration as well.
You need to know who is buying, who is selling, and why the consolidation formed in the first place.
Then you will know the true breakout direction for that consolidation.
Trade wisely,
Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
http://technitrader.com
MetaStock Partner
©2011 Decisions Unlimited, Inc.
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