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.

Related Articles
  1. Chart Advisor

    4 European Stocks to Consider Buying

    European companies, listed on US exchanges, that are providing buying opportunities right now.
  2. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  3. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  4. Technical Indicators

    Why MACD Divergence Is an Unreliable Signal

    MACD divergence is a popular method for predicting reversals, but unfortunately it isn't very accurate. Learn the weaknesses of indicator divergence.
  5. Chart Advisor

    Expecting a Big Breakout In These 4 Stocks

    These stocks are tightly wound following big moves, and upon breakout more big moves could ensue.
  6. Chart Advisor

    Trade Base Metals With These 3 ETFs

    News out of Alcoa is causing active traders to turn toward base metals for opportunities. Before diving into the market, check out the charts of these three ETFs.
  7. Charts & Patterns

    The Importance Of Tracking The Whisper Number

    Don't let the name fool you: Whisper numbers are making themselves heard. Here's why you should be paying attention.
  8. Chart Advisor

    Stocks With Buy Signals in a Bear Market

    The short-term trend may be down, but these stocks are showing strength to the upside.
  9. Chart Advisor

    ChartAdvisor for September 25 2015

    Weekly technical summary of the major U.S. indexes.
  10. Chart Advisor

    Downtrending Stocks to Short or Sell

    These stocks are trending lower and currently near a short sale areas, based on breaks lower and falling stock indexes.
  1. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  2. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  3. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  4. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  5. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  6. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!