All You Need To Know About Consolidations

Consolidations ( often known as ranges ) are some of the most challenging market conditions people face when trading the forex markets.

Usually consolidations begin after there has been a long trend present in the market. Traders using indicators like moving averages who may well have been in a small amount of profit from the trend tend to lose it all back when the markets start consolidating.

The wild swings up and down make the moving averages cross one another many times leading the trader to take lots of false signals.

It’s not only indicator traders who lose money during periods of consolidation ?

Support and resistance, supply and demand, traders using these strategies can also suffer heavy losses as they try to predict when the swings are going to end. The main purpose of today’s article is to show you a way to assign a level of probability of trade success when the market is in a consolidation phase, first we will look at what causes a consolidation then I will show you a method you can use to determine which part of the consolidation is most likely to result in successful trades.

 

What Causes A Consolidation ?

 

A Consolidation is primarily caused by professional traders taking profits.

The profit taking is what causes the preceding trend to stop moving either up or down in the first place. At some point the take profit orders that have come into the market from the institutional traders who were in profitable positions during the trend will consume all the additional orders coming into the market from the retail traders who were buying or selling at the top of the trend.

The movement generated by the take profit orders overwhelming the retail traders orders will create the first structure in the consolidation.

If the market was in a uptrend before the consolidation began, then the first structure in the consolidation will be a down move. When the low of this down-move has been made and the market is moving higher, you should mark the low on your charts as a support level/area.

If the market is indeed entering a consolidation ( at this point we wouldn’t know ) this low will be the most likely place the market will stop upon returning.

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In the image above you can see how the take profit orders begin to enter the market at the top of the uptrend.

The first drop is small, and the market manages to make a new higher high, when the high gets broken a whole mass of take profit orders start entering the market, this is the second drop marked on the image.

Once the down-move is over and the market has begun moving back up to the top of the highs the lows of the down-move need to be marked with either an area or support level, if the market falls back to these lows its likely it will turn back in the other direction, but this is only if it is entering a consolidation, you would still not be certain at this point.

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In a situation where a down-trend was taking place, the first component of the consolidation would be an up-move.

The high of this the needs to be marked by you as a resistance level, if the market manages to return, this will be the point where its most likely to fall if the market is entering a consolidation phase.

 

Two Sides To Every Consolidation

 

For a consolidation to form there at least needs to be one swing low and one swing high, the low and the high will form the support and resistance levels to which the rest of the consolidation will likely form.

I call these levels the upper and lower boundaries

The upper boundary is the resistance level, the most likely place for the market to turn back down if it returns.

And the lower boundary is the support level where the market is most likely to turn back up if it returns.

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The upper boundary is the place where the market has the highest probability of moving lower back to the lower boundary  due to the traders who sold up here wanting to defend their sell positions if the market returns.

At the lower boundary we have the traders who brought wanting to defend their trading positions, this means if the market falls back to this point its likely they will place additional buy trades to stop the market from falling below the lows.

Both the upper and lower boundaries will be present in all consolidations you see in the market, the image above was taken from a weekly chart of AUD/USD but it could have easily been taken from a consolidation on a lower time-frame.

 

How To Trade Ranges Properly

 

The majority of trading strategies available online are not suitable for trading consolidations.

Reversal strategies such as supply and demand will put you at a disadvantage if you attempt to use them when the market is consolidating.

If the market is moving higher from the support level established at the bottom of the range and you see a demand zone form, for the market to return to that zone it needs to move lower, unless the move lower consists of a quick spike, possibly from a news release, its unlikely the market is going to return to the zone.

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Many traders will still view the demand zone as a place where the market will turn, so upon hitting the resistance level found at the top of the range the market will begin to move lower, the supply and demand traders will watch the demand zone they identified as the market was moving up for signs of another move higher, they don’t realize the most probable path the market is likely to take is back down to the support level at the lower boundary.

Essentially their taking trades in the middle of the consolidation rather than the extremes of the consolidation at the upper and lower boundaries.

Establishing Probabilities

 

When you first identify the market has entered a consolidation, you should mark the upper and lower boundaries with horizontal lines.

The upper and lower boundaries are the two most likely places for the market to turn, this is down to the professional traders who have either bought or sold causing the consolidation in the first place, they have an interest in keeping the market in a consolidation which means every time the market comes down to one of the boundaries they are highly likely to buy or sell      ( depending on which boundary you’re looking at ) to protect their positions.

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This is a chart of the current consolidation taking place on EUR/USD

Notice how every time the market hit one of the boundaries it turned in the opposite direction, this is the professional traders defending their positions. The lower boundary has professional traders who brought protecting their buy trades while the upper boundary has traders who sold protecting their sell trades.

The best way to keep yourself out of bad trades when the markets consolidating is two split the consolidation into three parts.

The two boundaries upper and lower.

And the middle.

The middle of the consolidation can be found by drawing a Fibonacci retracement from the upper and lower boundaries or by using the cross-hair tool on MT4 to determine the overall range ( in terms of pips ) then halving it.

Now you have marked the three sections marked your able to establish where the best locations are for placing trades.

If the market is above the middle then you only want to be placing sell trades, whether this is using supply or demand or support and resistance is up to you, but you know when the market is above the middle of the consolidation the market has a higher chance of going down than it has of going up as it’s nearing the points where the traders who sold creating the upper boundary have placed their sell trades.

If the market moves below the middle then you only want to be placing buy positions because the traders who brought creating the first swing up will want to protect their own buy trades.

Another thing to take note of is how the consolidation in the image above contains a consolidation inside it.

Essentially we have a consolidation within a consolidation.

For a situation like this when there are multiple consolidations present within one larger consolidation what you need to do is split each consolidation up in to sections like I’ve just shown you.

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This smaller consolidation follows the same set of probabilities that are present in the larger consolidation.

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Each trade you place should be exited when the market reaches the opposite boundary, if you place a buy trade when the market reaches the lower boundary you should be exiting your trade at the upper boundary, the point where your take some profit off your trade is when the market comes into contact with the middle line, When the market encounters the middle line the probabilities of the market turning in either direction are relatively equal, therefore its best to if take some profits off your trade in order to protect yourself in the event that the market begins moving against you.

 

Summary

Consolidation can be very difficult to trade correctly, whilst its impossible to not lose on a couple of trades when the markets are in a consolidation the method described above is the best way to make sure your always placing the right trades in the right location.

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