In terms of technical analysis, consolidation is the movement of an asset’s price within a well-defined pattern of trading levels. Consolidation is generally regarded as a period of indecision, which comes to an end when the price of the asset breaks beyond the restrictive barriers. Periods of consolidation can be found in charts covering any time interval (i.e. hours, days, etc.), and these periods can last for minutes, days, months or even years. Lengthy periods of consolidation are often known as a base.
Once the price of the asset breaks through the identified areas of support or resistance, volatility quickly increases and so does the opportunity for short-term traders to generate a profit.
With Forex, price consolidation occurs when there is no obvious uptrend or downtrend in short-term time frames. With prices still fluctuating up and down, consolidation does not take place in ranging markets. In fact, consolidation is a period when prices are less volatile and are seemingly moving sideways. Market prices do not fluctuate and typically stay within a 10 to 15 pip range.
When currency traders identify a price consolidation, they usually anticipate a breakout to follow. A breakout occurs when prices break out of consolidation, penetrating the support, downward breakout or resistance, upward breakout lines. Forex traders look to make profits from consolidation and breakout. Because you cannot know while currency trading whether the market will break out of consolidation downward or break out upward, you need to prepare for both. This is called a straddle trade. In this situation, you would want to place an order to buy 15 pips above the resistance level and at the same time, an order to sell 10 pips below support level.
Although currency trading breakouts from consolidation can lead to profits, you can also trade from within the consolidation. You would not use a straddle in this situation. Instead you would sell at the resistance level with a limit at the level of support and a stop loss at the last level of resistance. Or you could buy at the support level and with a limit and a stop loss at the last level of support.
Many people trade when the price breaks out of the highest or lowest level of the consolidation. If prices break upwards, they buy. If prices break downwards, they sell. This decision is based on the supposition that the momentum of the break will be strong enough to push price further in the same direction.
This postulation has proven true in most instances. Trading at breakout can be very profitable. But it isn’t easy to decide when to exit a trade once its in-the-money. Any hesitation regarding when to sell can result in unanticipated losses as breakouts reverse directions very quickly.