What is Congestion
Congestion is a market situation where the demand of contract holders wishing to exit their existing positions is matched by the supply of willing participants wishing to enter into the offsetting position. It is often a period of time when a stock trades either below resistance or above support.
BREAKING DOWN Congestion
Congestion is a supply and demand trading factor that influences the liquidity and trading price of a security or trading instrument. Generally, 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 can help 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, focuses on price patterns. 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.
Supply and Demand
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 and the buyers are usually willing to pay a slightly higher premium. If sellers are stronger, the stock price goes down and sellers may be willing to receive a slightly lower discount. When there is a relatively equal balance of supply and demand then the price will trade within a tight range with minimal volatility. This range is referred to as an area of congestion by technical analysts.
Technical trading analysts will typically look at a number of factors when seeking to enter a trade. When faced with congestion, analysts usually see a high volume of trade orders on both the demand and supply side of the security, all around a certain price point. Thus, a congestion scenario leaves minimal opportunity for profiting on trade timing. As such, many buyers and sellers will be trading for the longer term value expectations. However, in some cases traders may choose to wait for a price trend to evolve before placing their trade orders since trends can often emerge from high volumes of trading.