What Is Congestion?
Congestion is a market situation where the demand to buy an asset or trading instrument is matched by the seller's supply. This results in the price not moving significantly, making the price action consolidated or look congested. Congestion is a trading range or sideways price movement, showing the balance between buyers and sellers.
- Congestion occurs when the price is relatively stable or moving sideways as a result of buyers and sellers meeting each other with equal strength.
- Congestion ends when either the buyers or the sellers overpower the other, and the price moves out of the congestion price range, typically on high volume.
- Congestion occurs because there are no new developments in an asset, and therefore buyers and sellers are balanced. Or, traders and investors may be digesting a big move before deciding what to do. It can also occur prior to a major news announcement as traders await the news.
Congestion is a supply and demand trading factor that influences the liquidity and trading price of a security or trading instrument. Congestion is a concept used by technical analysts and technical traders.
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 (or any asset) depends on the strength of the buyers and sellers.
If buyers are stronger, the stock price goes up as the buyers are willing to pay a higher price. If sellers are stronger, the stock price goes down, and sellers sell at a lower price. 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. When the price is moving sideways, that is also referred to as congestion.
Causes of Congestion
Congestion can occur because there are no significant developments within an asset, and so buyers and sellers are relatively balanced, which keeps the price relatively stable.
Congestion also occurs during periods of indecision. For example, the price may shoot up, but then start moving sideways. This sideways period is caused by traders reassessing the outlook of the asset and digesting what just happened. This type of congestion is often short-lived, while in the former case, congestion can last a long time without any catalysts to increase the buyer or seller strength.
Congestion also sometimes occurs before a major news announcement as most investors and traders are waiting for the news, and therefore the price isn't moving much. For example, a stock may have a tight range (congestion) before a highly anticipated earnings release. After the earnings are released, the price is likely to move violently out of the congestion area.
During periods of congestion, typically only short-term traders will attempt to profit during the congestion. This is because the price movements are often minimal, but provide enough movement for a day trader or short-term swing trader to snag a potential profit.
Trading volume tends to drop off the longer congestion lasts. This is not always the case but is the general tendency. Volume tends to pick up when the congestion ends. The congestion is over when there is a breakout, typically on larger-than-recent volume, and the price moves outside the congestion range.
During a congestion period, the price will move between support and resistance. When the price breaks above resistance or below support, it indicates that the buyers or sellers have overpowered the other side, respectively.
Some investors will enter during congestion, assuming that the stock price will continue to rise after the congestion ends. This is more likely to be the case if the price was in an uptrend leading into the congestion period.
Other traders may wait for the price to break out of the congestion before entering a trade. For example, they may buy if the price moves out of the congestion price range on high volume. Or they may short sell if the price drops below the congestion price range on high volume.
Short-term traders may also try to take advantage of the congestion by buying near support and selling or shorting near resistance. They may also fade breakouts which have low volume, assuming the breakout will fail and the congestion will continue.
Example of Congestion in the Currency Market
The USD/CAD forex pair—which has a rate reflecting how many Canadian dollars (CAD) it takes to buy a United States dollar (USD)—had back-to-back congestion areas as shown in the chart below.
In April, the price was bound between 1.33 and 1.34. There were minor intraday breakouts of this range but no closing prices outside the range. On April 23, the price spiked out of the range but then quickly entered another congestion area. This shows hesitation on the part of buyers as their strength was quickly matched by eager sellers.
On the next major congestion, the price moved up and out of the congestion but quickly failed and began to drop. That is a false breakout. The price proceeded below the bottom of the prior congestion area and continued to drop.
Two shorter-term congestion areas are also marked on the chart as small congestion areas.