A healthy consolidation is often an important prerequisite for a stock emerging into a new sustainable trend. A consolidation occurs when a stock transitions from a trending move to a sideways trading range as buyers and sellers reach equilibrium. This consolidation or trading range serves a vital role in the life of the larger trend, as it allows for the exchange of funds from weak participants to stronger ones. This is healthy for a stock, as these new participants are less likely to get shaken out on typical market noise.

IN PICTURES: 7 Tools Of The Trade

A sound base often takes time to develop, and quick or choppy bases often result in failed moves as there are still many participants from the prior trend anxious to take their profits. Once a stock emerges from a healthy consolidation, the base will usually serve as a strong support or resistance level because that area is filled with other traders who missed the breakout and are anxious to not miss a second opportunity. (For more, see Consolidation - Trade The Calm, Profit From The Storm.)

Longtop Financial Technologies Limited (NYSE:LFT) is a good example of a stock that recently emerged from a several month long base. LFT began a pretty volatile trading range in May and June, but as the year progressed, the trading range began to narrow as it consolidated. This is typical of consolidations, as a stock's trading price reaches an equilibrium point between buyers and sellers. More often than not, the resolution of the consolidation is in the direction of the trend leading into the base. In LFT's case, this proved to be correct, as LFT broke out of the base in mid-November. If the breakout is to be valid, LFT should remain above the $31-32 area on any weakness.



Source: StockCharts.com

Rackspace Hosting (NYSE:RAX) is an example of a stock that cleared a base, but rather than following through, has settled into another consolidation. This is often referred to as a base-on-base pattern, as the stock respects the prior base as support, but continues to trade sideways. These bases should be watched, as they provide clear trading signals, with a breakout above the new base acting as a possible long signal and a break below signaling a failure to complete the original breakout. (For more, see The Rectangle Formation.)



Source: StockCharts.com

Vistaprint N.V. (Nasdaq:VPRT) is another stock working on a base-on-base pattern, although it did attempt to break out in November. It quickly fell back into the secondary base, but respected the original base (June-September) as support. While the breakout failure can be labeled as a bearish development, VPRT did respect support near its rising 50-day moving average, and recently gapped higher from this support. With this strength, VPRT could be headed back for a retest of the recent highs.



Source: StockCharts.com

Lumber Liquidators, Inc. (NYSE:LL) is another variation on this theme, as it has been grinding higher for several months. During this time, LL has built and broken out of a couple bases. The first breakout came in an August gap higher, and while LL continued to move gradually higher, the action was more like a base-on-base pattern. It recently cleared this base in November, and is in the process of testing the breakout area as support. If it holds this area, it could resume the breakout shortly thereafter.



Source: StockCharts.com

Bottom Line
While stocks will often fail on a breakout attempt, the few that continue to follow through and break to new highs will more than make up for the few failures. Stocks that are clearing a base should be less prone to an outright failure, as shares have already been exchanging hands prior to the breakout. There shouldn't be as many traders looking to cash in for a profit, and therefore willing to hold on for bigger gains. Pullbacks should be met with either new buyers who feel like they missed the boat, or existing holders adding to positions. These pullbacks often offer trading opportunities if the trend remains healthy.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Joey Fundora did not own shares in any of the companies mentioned in this article.



Filed Under:
Tickers in this Article: LFT, RAX, VPRT, LL

comments powered by Disqus
Trading Center