DEFINITION of 'Congestion'
Congestion is a market situation where the demand of contract holders wishing to exit their existing positions exceeds the supply of willing participants wishing to enter into the offsetting position. It is a period of time when a stock trades either below resistance, above support or both. During times of congestion, contract holders may be forced into paying a premium or selling at a discount.
BREAKING DOWN 'Congestion'
There are two primary ways in which analysts analyze securities: fundamental analysis and technical analysis. Good analysts know how to employ both. Fundamental analysis is said to help analysts determine what to buy, while technical analysis helps analysts determine when to buy it. Fundamental analysis studies the direction of business performance. If revenues and earnings are going up, it is a good indication the stock price will also go up in the future. Technical analysis, on the other hand, only looks at price. If the price is going up, it means the stock is in an uptrend. If the stock price is moving down, it means the stock price is in a downtrend, and technical analysts believe the trend is your friend. There is one other direction stock prices can go: sideways. Sideways price action is also known as congestion.
Technical analysis is based on many different theories, one of which is auction theory. Auction theory says there are a number of buyers and sellers in the market at any given time, and the price of a stock depends on the strength of the buyers and sellers. If buyers are stronger, the stock price goes up. If sellers are stronger, the stock price goes down. If there is a balance, that is, if sellers are just as active and strong as buyers, the price stands still and tends to trade within a tight range. This range is referred to as an area of congestion by technical analysts.
Congestion Equals Indecision
Congestion in the literal sense might refer to traffic, too many cars in the same highway or too many pedestrians on a hiking trail. For technical analysts, congestion refers to too many buyers and sellers. The room is so full, the price does not move. As some of the buyers begin to move out, sellers take over the price and the price goes down until it reaches another congestion area, or vice versa. Prices can trade in a congested area for an extended period of time before breaking out up or down, so most traders do not like to trade these areas until they see a price break.