Trend Trading – Consolidations Pause or Breakdown? Part 1

Trend trading is immensely popular and a good trend trading system with a proper trading plan can be very profitable. One of the questions I get asked allot is something along the lines of “How do you know if you’re in a sideways pattern, if it’s a pause or a breakdown in the trend?” It is a very good question and we’re going to go over that very quickly here.

There are many trend trading software programs available designed to help you find emerging stock trends and capitalize on them. The key to a good trend trading strategy is to understand how to trade trends effectively and understand when it may be breaking down or ready to continue.

First let’s explain what a good trend is. In this example, we’re going to use an up trend.  An up trend is defined by a series of higher highs and higher lows.  With higher highs and higher lows, price is getting higher, higher, and higher and the low prices are getting higher, higher, and higher. Trends tend to last for long periods of time and if you can “catch a trend” early you can reap huge rewards. This is likely the main reason why trend trading systems are so popular.

consol 3 300x188 Trend Trading   Consolidations Pause or Breakdown? Part 1

Let’s take a look at a chart.  Here we can see a stock that’s in an up trend and we know that because we have our first low here and it makes a higher high with a higher low, then a much higher high, makes another higher low and makes another higher high up near the top.  We can clearly see the stock is in an up trend.

So what are some key points to determine whether or not it’s a trend consolidation or a pause?  Well the first point to consider is that stocks are going to pause and rest by correcting sideways after a prolonged up move.

They’re not just going to go up indefinitely because it can’t sustain those prices.  Eventually it’s going to reach a price where people are not willing to pay any higher and then it’s going to fall.  So that’s basically what’s happening when a stock gets too high in price.

Now, with a correction or a consolidation pause, the price is going to go higher, take a rest and then continue onward or pull back and continue onward and then pause and then continue onward and that’s basically what’s happening in an up trend.  These pauses are very healthy for the move in the stock, which brings us to the second point.

A consolidation is healthy as it helps prepare the stock for another run to the upside.  So, again, it goes up, pauses, continues.  This pause is the buyers taking a break, they’re regrouping, gathering momentum, getting ready for the next big move, when the volume picks up again and it breaks out, they’re all jumping in again and fueling the price higher.

The last point here is many traders are unable to determine if this is a healthy pause or an unhealthy topping phase.  We’re going to cover that a little more detailed in the later on, but generally speaking, a healthy pause is going to be these nice controlled pull backs and pauses and going forward.  An unhealthy topping phase is going to be very whippy in price because the buyers and sellers just don’t know where they want to go with the prices, so it’s going to go up and down, up and down as they continue to swing from team to team, from buyer to seller, trying to determine and pick a winner.

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If we look at an example of the chart again, we’ve got the stock that’s in an up trend and things are very calm and controlled, nice and smooth, and then finally, we have the nice breakout with this huge volume behind it as opposed to a chart that looks like this, which is extremely whippy.

Here you can see the prices are getting higher for a period of time, but the prices, when it got up in here, got very whippy.  There are big bars here, as the volatility was really picking up.  It goes up, huge green day and then a huge down day, fights back, goes back down, up, down, just doesn’t know where it wants to go. This is indicative of a possible topping phase and these are the type of patterns you want to try to avoid.

In trend trading part 2 I will show you the 3 things to look for to confirm you are in a healthy sideways trend consolidation.

Dave

Founder of Market Insiders Club.com. President and CEO Dynamic Wealth Financial Inc. Author of Trading Master Plan

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Shantu Dand - October 4, 2010

This is good education for nubies and good reminder for old hands. Thanks.

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