Forex Consolidation Trading - Trade The Calm, Profit From The Storm

By Richard Lee AAA

Much like the first dynamite compound invented by Swedish chemist and engineer Alfred Nobel, consolidation periods and patterns in the currency markets can explode, leading to great profit opportunities for the FX trader. Sometimes suggestive of indecision, consolidation periods are great for capturing potential because the burst of directional action that follows can last for an extended period.

Understanding and trading on consolidation patterns will give the currency trader in the know two "edges". First, the trader can hold his or her initial position for a shorter amount of time, thus minimizing the risk of holding positions in the case of higher rollover interest. Second, the profit potential from such a position can be big, as long as the trader follows strict, disciplined money management rules. Without money management, the trader might as well be playing with fire. Here we look at two different consolidation patterns and give you a step-by-step explanation of how to trade them.

The Flag - Continuation of the Trend
The flag formation is one of two consolidation patterns that can lead to great profit opportunities. Common in the currency markets, the flag formation serves as an indication of continuation (i.e. a continuation pattern). This type of consolidation occurs after a significant uptrend and is usually referenced as a stopping point before further strengthening momentum ensues. With this type of formation, the duration of the consolidation period is rather short and tends to go against the previous uptrend direction.

Figure 1 presents an example of a flag formation in the GBP/JPY currency cross pair.

FX_Consolidation_6r.GIF
Figure 1 - A great continuation suggestion following the flag formation

Let's take a step-by-step approach to identifying and trading the flag formation seen in this chart:

  1. Apply trendlines to accurately identify the flag formation: First, we establish the lower support trendline by connecting the lower wicks of the candles at point A. Then we establish the upper trendline at point B by connecting the topside wicks. Note that both lines should be relatively parallel - any deviation may be indicative of a different pattern.
  2. Zoom into the exact points where the price action approaches either the upper or lower trendline: In Figure 2, we zoom in on an approach of the upper resistance ceiling. Once we have a close of the session above the trendline, the entry should be placed 5 pips above the high. This would place the entry at 210.10 (point X).
  3. Always place a corresponding stop loss: Sound money management should always be applied to any trading position. In this situation, the stop-loss order will be placed two-thirds below the previous session\'s high. The underlying theory is simply that if the price breaks back below the upper trendline, the close above was simply a fakeout and the trend is being contained. In this trade, the stop would be placed at 209.77 (see Figure 2).
  4. Taking a short-term stance: Here, a trader can hold for the day and close the trade before the New York markets close in order to avoid the rollover on the position. If the trader takes advantage of the short-term explosion, he or she has the potential to capture 95 pips (profiting from the high at 211.05) while maintaining a 2:1 risk-reward ratio. But the trader can also opt to hold on for longer-term gains. If the trader holds on longer, he or she could realize a much larger profit - in this example, the move topped out at 213.

FX_Consolidation_7r.GIF
Figure 2 - X marks the perfect entry.


The Broadening Formation - Consolidation before the Reverse
Like the flag formation, the broadening formation - our second consolidation pattern of choice - is also found in an uptrend, but it indicates a reversal of the trend, rather than a continuation. Similar to a staid rectangular consolidation pattern, the broadening formation is great for establishing a top in an uptrend or a bottom in a downtrend, and it is thus suggestive of a near-term reversal in the price action. Here, traders are consolidating their positions by establishing an upper and lower trendline. However, the swings become longer and larger as compared to earlier fluctuations. The strong battle between buyers and sellers ultimately ends when the price action breaks the lower (or upper) boundary and bearish (or bullish) momentum is established.

Figure 3 presents an example of a broadening formation in the AUD/USD major pair.

FX_Consolidation_8r.GIF
Figure 3 - Textbook broadening formation leads to explosive gains.


Let's take a step-by-step approach to a shorter time frame application of the broadening formation in this chart:

  1. Identify the broadening formation through diverging trendlines: Before trading the formation, it\'s important to clearly establish the pattern. Here in Figure 3, we apply the lower trendline by connecting the lower wicks at point A. Then we connect the topside wicks at point B. Rather than run parallel as they do in the flag formation, the trendlines in this formation will diverge. It\'s important to see that divergence - otherwise, another formation or pattern may be in the works, misleading the trader.
  2. Apply the entry at the exact break: In Figure 4, we zoom in and see the close below the bottom trendline. This is suggestive of a break, so a currency trader would place the entry 5 pips below the low of the session. In this example, this would put the entry at 0.7493 (point X).
  3. Use proper money management: We can\'t forget to apply disciplined money management here, so a stop loss will be added 30 pips above where the lower trendline crosses through the closed session. In this case, the trendline would be placed at 0.7511 and our subsequent stop at 0.7541. With 48 pips of room, due to the stop-loss order, we are now looking for a minimum of 96 pips in maintaining a 2:1 risk-reward ratio.
  4. Taking a longer term stance: Although offering a short-term direction in price, the broadening formation tends to spark longer-term trends. As a result, in this case a trader may decide to take profits at 0.7445 (a 1:1 risk reward) or hold on to the longer-term position. In the case of the longer term, the spot price declines before establishing a bottom at 0.7266 - nearly 230 pips from the entry, and a more than adequate 2:1 risk-reward ratio.

FX_Consolidation_9r.GIF
Figure 4 - X marks a great entry for profit potential.

Conclusion
Both of these consolidation patterns and their corresponding strategies can be executed by both the novice and the expert trader, allowing the individual to isolate great potential profit opportunities in a short amount of time. The flag formation offers opportunities to trade on a continuation basis, while the broadening formation offers opportunities in reversal situations. Either way, the trader will be taking advantage of the powerful directional bias that occurs following consolidative neutrality.

For further reading, please see Market Reversals And How To Spot Them and Channeling: Charting A Path To Success.

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