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How To Spot And Trade Congestion Patterns

07/25/11 01:05:16 PM
by Billy Williams

Congestion patterns form when volatility declines and traders are unwilling to take control of the trend, but it is in these pauses in between trading that breakouts can occur.

Security:   BIDU
Position:   Hold

Trends and trading ranges are to stock trading what yin and yang are to the natural universe, which are the coexistence of two opposite forces that, despite being diametrically opposed, still manage to exist in a type of harmony. Likewise, the principle of price contraction and expansion mirrors a similar working harmony as price moves from expansive price action in the form of trends to the contractive price action of stagnant trading ranges or consolidation patterns.

It is during this phase of price contraction, however, that many forms of price consolidation can develop, such as the aforementioned trading range but also price patterns, which reflect a pause in the direction of the primary trend, allowing traders to capitalize on the resumption of that dominant trend.

Of all these consolidation patterns, congestion is often the most confused form of price contraction to understand which, unfortunately, results in a lot of missed trading opportunities by traders who are unaware of the important price distinctions that are associated with congestion patterns.

While a congestion is usually referred to as a series of trading days where no significant change in price materializes, it allows market participants to reevaluate the market and the environment that leads market price. It is within these clearly defined price ranges where the potential for explosive breakouts can occur due to a prolonged period of listless back-and-forth trading, and a buildup of orders outside this price range may result in a rise of demand so great that it forces price to move powerfully outside this range and into a period of runaway price expansion as the primary trend resumes its course. See Figure 1.

FIGURE 1: BIDU. BIDU traded within a congestion pattern from later 2009 to the early part of 2010 when, on February 10, 2011, its price broke out, retraced, then traded powerfully to the upside. During this congestion phase, price was listless, trading on low volume until enough buyers simultaneously forced price outside BIDU's price range and back into a trend phase.
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A hallmark characteristic is the decline in price volatility as congested price ranges occur and steepen as no single side -- buyers or sellers -- appear to take control of the trend. As a matter of record, volatility will revert to its mean at some point when an outside catalyst, like rising demand, occurs and causes a change in the direction of price itself.

Trendlines are especially useful to the market technician as a means of identifying key price levels of support and resistance, but price itself is the ultimate indicator of predicting a runaway move of enormous magnitude that can result in a stock going on to achieve a 50%, 100%, or even greater gain. However, in order to achieve those types of potential gains, you must have a superior form of making entries to initiate a position.

In order to accomplish that objective, you need a formula or clearly defined setup to trigger the trade just as price is rising up through resistance for a long entry or slicing through support to short entry.

Depending on the length of the period of congestion, the more possibility there is for a buildup of orders and thus a larger potential surge in volume on a breakout. Leading up to that condition, you must have observed price to confine itself to a range that is 1.62 its average range of the last 20 days for 10 days or more or any time that prices are confined within one day's range for seven days or more.

This type of congestion pattern was identified in a study conducted by hedge fund manager Mark Boucher in his book "The Hedge Fund Edge," which goes on to detail that runaway stocks as well as other types of tradable securities exhibit this type of contracted price range while in a congestion pattern before breaking out and going on to achieve stratospheric gains.

Once price begins to break out of a tightly defined trading range as detailed, the entry signal is taken in the direction of the primary trend as it breaks through resistance or below price support, depending on the context of the market.

That said, no method is foolproof, so remember to place a stop immediately after entry on the opposite end of the congested price range or within a clearly defined percentage of the position itself to avoid any unexpected move in price that goes against your position, ensuring that you avoid an unnecessary and steep loss.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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