Consolidations Ready For A Break Higher

By Investopedia | July 01, 2014 AAA

Consolidations are when the price action of a stock becomes tightly contained following a trending move. Consolidations can take on all sorts of shapes and characteristics. One in particular can be useful for trading purposes since the consolidation itself shows there is still short-term buying interest. The longer-term buying interest of the trend – combined with the short-term buying interest of the consolidation – indicates that the next likely move for the stock is higher. 

Many traders wait for a breakout of a consolidation, believing the breakout provides confirmation of the next move. That isn't necessarily true, since false breakouts can occur even with this confirmation. This presents two options. Take a long trade as soon as you see the consolidation pattern discussed below, or wait for the breakout. The former keeps risk lower since the entry point is closer to the stop level. The latter has slightly more risk, but may give traders a bit more confidence in taking the trade. (For related reading, see: Simple Way To Avoid False Breakouts.)

U.S. Silica Holdings Inc. (SLCA) has more than doubled in price since February, and the price has been consolidating since the start of June. The consolidation is still showing there is upside strength because the second swing low on June 20 was higher than the swing low on June 13. A move above $55 will break the consolidation and indicate another move higher. The price target is $59.50 and a stop can be placed below $51.

Moody's Corp. (MCO) is currently trading near the middle of a trend channel. This consolidation could be pause before a decline back toward the low of the channel, or a pop higher toward the top of the channel near $91.25. On June 16 the price made a swing low at $84.48, proceeded to make a new high at $89.08, but when it retreated the price made a higher low at $84.54. The price has been rallying back toward the high since. This shows there is still buying interest and the price is likely to test, and potentially break, that high before heading back toward the channel low. Given the choppier tendency of the stock, minimize risk with a stop below $85.70. To give more room place a stop below the recent swing low at $84.50. Initial target is $91.25 based on the trend channel, but there is upside potential beyond if the long-term trend continues. (For related reading, see: How To Trade With Price Channels.)

Brookdale Senior Living Inc. (BKD) was in a trading range for all of 2013, broke higher in early 2014, but could be ranging again. Whether the price breaks above the June consolidation will tell the tale. Following a pullback in April and early May the price rallied through the rest of May and then made a June low at $32.46. In the latter part of June the price has rallied and created higher low. That indicates there is still buying interest within the choppiness. A rally above $34.20 could be enough to trigger a break of the April high at $34.80, ushering in the start of a longer-term up wave which could take the stock to $37. Stops can go below $33 or $32.40. (For related reading, see: 3 Reasons Not To Trade Range Breakouts.)

Herbalife Ltd. (HLF), after a very weak start to the year, has been moving higher since April. The price is consolidating in June, with the first pullback on June 13 finding support at $62.45, and the June 24 pullback finding support at $63.51 (higher low). A break above the consolidation high at $66.81 signals another wave higher. This is a very important juncture for the stock, as this consolidation aligns with a much larger consolidation from earlier in the year when the price was trending lower. A break higher from this point, reverses the longer-term downtrend and leave open space until resistance near $76. Stop loss orders can go below $63.50 or $62.40.

The Bottom Line

Consolidations provide a way to get in on trending moves with relatively low risk when compared to a random entry where a stop level can be hard to pinpoint. No trading method is perfect. though; even if the price breaks out in the intended direction it doesn't mean it will reach the price target or produce an actual good reward-to-risk ratio (relative to the theoretical one). Trade in the direction of the trend and aim for a target that produces a bigger return than what is being risked to give yourself the best chance at success. Also control position size so that one loss doesn't significantly draw the account.  

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