The only way a market can stop moving in the same direction is if a pullback or consolidation takes place. Any forex trader could tell you what a pullback or consolidation is but you would be hard pressed to find a trader who can tell you what a pullback or consolidation actually means for traders in the market.
When traders see a pullback or consolidation they do not believe there is much difference between the two, the only difference the trader see’s is when a pullback forms the market moves against the trend and when a consolidation forms the market moves sideways. This is as far as their understanding goes, what the trader doesn’t realize is consolidations and pullback will change the expectations of retail traders in the market in completely opposite ways.
We’ll start by looking at what causes a pullback and consolidation to take place and then I’ll show you how they change the retail traders outlook on the market direction due to the way they are constructed.
Created By The Same Cause
Both pullbacks and consolidations form in the market due to bank traders taking profits.
The reason why there are structural differences between the two i.e a pullback moves against the trend whereas a consolidation moves sideways, is because of what the banks do when they’re taking profits.
In a consolidation scenario the banks begin taking profits off their trades which causes the current trend to stop and the price to move against the trend.
Reversal traders will see the movement against the trend as a complete trend reversal, in other words they believe the entire trend is changing rather than just a pullback or consolidation forming. As the price continues to move in the opposite direction to the trend the reversal traders will place trades under the impression they are getting in to an early trend reversal.
Now we also had trend traders placing trades in the direction of the trend before the banks started their profit taking. When the market starts to move against the trend, due to the profit taking, the trend traders who have trades open in the direction of the trend, will see their trading positions turn from possibly being at a small profit to being at a loss, these traders will end up closing their trades if the profit taking keeps pushing the market against the trend.
What you need to understand about both the trend traders and reversal traders is how they unknowingly put the same type of order into the market because of the banks taking profits. Even though they are making completely different decisions i.e trend traders closing losing trades, reversal traders placing trades, the orders they are putting into the market are exactly the same.
You can see how the initial move created by the profit taking pushes the market against the trend. The area I’ve shaded green is the point where a large number of retail traders are in open short trades because they believed the downtrend was going continue. Their now starting to close their short trades due to the market moving against their position, closing their trades means they’re unwillingly putting buy orders into the market.
Meanwhile the move up has made reversal traders think the trend is reversing so they have started to place buy trades with the expectation the market is going to climb substantially higher.
Both the reversal traders and the trend traders are putting large quantities of buy orders into the market.
With the majority of the orders coming into the market being buys the banks can now place sell trades, when enough buy orders are available the banks place their sell trades and the market will move down, this move down establishes the upper boundary of the consolidation.
At this point there would be no way to tell if a consolidation is forming or the down-move is a continuation of the downtrend, as the market comes into contact with the point where the initial move up took place, the banks decide to use the new influx of sell orders to take more profits of their trades which causes another move up, thus creating the lower boundary of the consolidation.
What A Pullback Really Achieves
The big difference between pullbacks and consolidations lies in what they make retail traders believe about the market direction.
When the market comes to a stop and begins to consolidate traders will still sell on each swing in the direction of the trend because they’ll believe the trend is continuing.
When a pullback forms, traders will begin placing trades in the direction of the pullback depending on how far the pullback manages to moves against the trend, if it moves back a large enough distance traders will stop trading in the direction of the trend and start trading in the direction of the pullback.
Lets take a look at the pullback on AUD/USD which occurred after the market dropped into a downtrend.
I want you to keep your eye on the far right of the chart as I show you how the traders belief changes as the pullback moves further and further against the trend.
Bank traders had been taking profits off sell trades as the market began to bottom out just before the pullback started.
When the market failed to make a lower low banks began taking profits again which caused another move up. To begin with the move up looked like it was part of a bigger consolidation which was starting to form, this all changed when the swing highs of the down-move were broken, at this point traders started to believe the market could be reversing from its downtrend as a higher high and a higher low usually signals a change of trend.
By the time the market has moved this far people are starting to see the pullback as a trend reversal, the fact a pullback has developed on the pullback itself is another sign traders will point to which tells them a new trend is forming. By this time the bank traders profit taking has now stopped, the only reason the market is continuing to advance against the trend is due to retail traders placing buy trades and intra-day bank traders taking advantage of the profits available on this swing higher.
Intra-day bank traders have vastly different profit expectations and objectives to other bank traders.
Whereas overall the banks decide when the market trends, when it consolidates and when it ends, intra-day bank traders are present to take advantage of a much smaller range of market movements. These traders will be getting in and out of trades in a much shorter space of time, they’ll be placing buy trades on the lower time-frames i.e 1 hour and below to make money from the retail traders who sell on small movements against the pullback.
So even though the pullback is against the direction of the main trend there will still be other bank traders making money from the pullback itself.
As the pullback continues the majority of the traders in the market now believe the pullback is a trend reversal, the amount of time the market has now been moving against the trend coupled with how far the market has manged to move against the trend makes traders believe the move up is set to continue.
Since the retail traders now believe the pullback is a trend reversal rather than a pullback to the trend itself the big difference between pullbacks and consolidations is revealed.
If a pullback moves far enough against the trend it will make retail traders believe the trend has reversed.
When a trend changes into a consolidation, traders will be placing trades both against the trend and in the direction of trend, as to some people it will look like the market is going to move up and to others it will look like its going to move down.
The pullback ends when the banks have enough buy orders available to place their sell positions, when their trades are placed the buy orders from the retail traders are consumed and the market begins to fall. Now all of the retail traders who have placed long traders start to lose money and are forced to liquidate their losing trades, the majority of the down-move which follows is caused by the long traders closing losing trades, its their orders which are pushing the market down.
At the most basic level both pullbacks and consolidations are used to mess up retail traders expectations of where they think the market is going to move.
The only difference is when a pullback forms, if its large enough, it will make ALL retail traders place trades in the opposite direction to the trend because they’ll believe the pullback is a trend reversal. A typical consolidation cannot do this because traders will not only place trades in the direction of the trend but also place trades counter to the prevailing trend due to the way consolidations form from multiple up-swings and down-swing.
What this means is in a pullback scenario the banks will be able to place bigger trades in the direction of the trend because the majority of the retail traders will be placing trades in the direction of the pullback. If the banks wanted to place large positions in the direction of the trend when the market is consolidating then they must make the market consolidate for a long time, otherwise there will not be enough orders available for them to place their trades.
As with a lot of things in trading pullbacks and consolidations seem like a piece of price structure which don’t have much relevance in the market, most traders see pullbacks and consolidation as things which cause a market to stop trending when really they accomplish very different goals in the market.
Hopefully from the information I’ve given you in this article you can see pullbacks and consolidations have dramatically different effects on what retail traders believe about the future market direction and how this effects the decisions the bank traders will make in regards to placing trades.