Active Trader Magazine

Trading Strategies

Finding consolidation breakout opportunities

By Active Trader Staff

One old trading saw that holds true is that markets spend much more time trading randomly or stuck in trading ranges than they do trending. But traders often look for big moves to emerge from tight consolidations, believing that high-momentum moves follow extended low-volatility moves. Does this mesh with reality?

Figure 1, a daily chart of the Russell 2000 index ETF (IWM) between early November 2011 and mid-March 2012, illustrates the balance between trend and congestion in microcosm. Two of the most notable stretches during this 18-week period were the rally that occurred between Dec. 14 and Feb. 3 and the extended consolidation that formed immediately after it. 

Both phases appear to be fairly extreme on the chart — the market looks like it moved almost straight up during the roughly seven-week rally, while during the month-long trading range, price never closed more than 2.3 percent below the Feb. 3 close (the initial high close at the top of the rally) or more than 1.9 percent above the Feb. 10 close (the initial low close). Prior to the rally, IWM traded with more volatility: Price was in a wider trading range before selling off sharply, rebounding back toward the high of that range, and then consolidating and pulling back again before embarking on the rally.

But despite the almost uninterrupted appearance of the rally (which accounted for only 40 percent or so of the time covered in this chart), the price action was not all straight up during this phase. Even though IWM rallied 11.91 points from Dec. 14 to Feb. 3 — a 17-percent gain — 10 of those points occurred during just six of these 35 trading days. The rest of the time the market was moving incrementally higher or lower, or moving sideways in consolidations, as highlighted by the additional horizontal lines within the trend.

For the complete article, see the May 2012 issue of Active Trader magazine. Click here to subscribe.

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