Investing With Options header image ≡ Menu

Just Released: Get Your FREE Iron Condor Trading Toolkit


Click Here to Download

Consolidation Patterns Explained

The market has been showing a significant amount of volatility recently, and it's probably been warranted. The fears of market structure breakdowns and the debt crisis in the eurozone have been providing plenty of opportunities for traders on both sides. But the past two days, we've been stuck in a range and haven't moved as much as many momentum players would have hoped.

What gives?

What is happening is that the markets are currently in a consolidation phase. In basic technical analysis, these kinds of patterns are known as flags, pennants, or channels. But knowing the patterns don't explain why they happen.

I'm going to explain why.

Technical analysis in its most basic form is a time series analysis of price, and this price movement is the overall measurement of two forces: supply and demand. When there is more supply, price goes down; when there is more demand, price goes up. Quite often, these forces will oscillate around each other as price will tend to mean revert around a particular price.

So if we run up very fast, and buyers aren't willing to continue at that price but there are willing sellers, we will see price fall until we find buyers willing to trade at that price.

If we move fast to the downside, sellers may run low, and buyers will defend a position, and there may be some short covering as traders take profits to the short side.

When we finally get a "breakout," either the sellers or buyers get exhausted and we usually see fresh capital enter the market or a significant flow out of the market into other asset classes. Only when we have confirmation of this will we see whether we get a continuation in the longer term trend or a reversal.

The next time I write about consolidation patterns I will discuss how price behavior can be modeled after a harmonic oscillator and some other technical aspects of these kind of patterns.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/