The Breakout from Consolidation

January Soybeans

Traders call a sideways pattern a consolidation, and these patterns set a market up for an eventual big move. In my experience, there are a few chart patterns that definitely place the odds in our favor; one is the consolidation or, more specifically, the breakout from a consolidation. In this issue, I’ll share this powerful trading tool with you: the breakout from consolidation. We’ll discuss what it is, how to spot it and how to use it for profitable opportunities in your own trading.

Think of a market bouncing off “support,” like a ball bouncing off the floor. If the floor is a deck four stories off the ground, it will bounce as long it remains on the deck. But if it subsequently falls off the deck, it drops lower.  Alternatively, “resistance” is like a ceiling. But if a glass ceiling is smashed, the birds are free to fly higher still.  

Support and resistance levels are very important to traders. When a market is in a relatively flat range--holding at support and failing at resistance--this is termed “consolidation.” Consolidation is nothing more than an inability by either bulls or bears to win the battle.

When the market holds at some level, rallies and then again retreats to that same level, it appears cheap. Those bulls who missed the first rally feel that they have a second chance at cheap levels and step up to the plate. The shorts, especially those who are scalping and sold at higher levels, see the market start to bounce and are induced to cover their shorts before their paper profits disappear. This additional buying--short covering--adds fuel to the bull move.

The reverse occurs when the market rallies to the level of previous failure, the resistance point. Some of the longs who previously purchased at support may feel the market is looking expensive and cash in. Bears, who missed selling the last rally, will consider this a second chance and start to get busy selling. 

The market starts its retreat and other longs--who don’t wish to see their paper profits disappear--sell out, thus adding fuel to the bear fire. We know that if a market fails at a resistance level on numerous occasions over a significant period of time and then proceeds to trade above that level, this is a sign that the bears have lost the battle. 

The buying interest was finally strong enough to overwhelm the selling interest, and the defensive ceiling built by the bears has been shattered. The opposite is happening if a support level is broken. In simpler terms, a break above resistance or below support indicates there’s likely a major shift taking place in the supply/demand fundamentals of the market in question. 

Soybean Breakout

Take a look at the 1988 oats chart; the all-time monster oats rally, which drove prices to levels never seen before and reached highs not exceeded for the following 20 years. Look at how long the consolidation was that preceded this bull move.

July 1988 Oats

These patterns are powerful, not all that common and can certainly occur in varying time frames. Here are a few other examples; wheat illustrates a potentially false breakout--which, in short order, proved true--and the fact that breakouts from consolidations can occur during a trend move, not just at the beginning. I’ve found a potentially false breakout that proves true in short order via a successful second attempt. Certainly, these patterns can signify breakouts to the bear as well as the bull side, as the cattle example shown below illustrates.

2008 Wheat

Cattle (Downside Breakout)

False breakouts: Although this stuff is good, and I believe it works more often than not, you didn’t think this would be that easy, did you?

When I first discovered technical analysis, I studied the profitable examples in books and thought this trading gig would be a piece of cake. Unfortunately, like all of life, it doesn’t work all the time. There have been many false breakouts from consolidation, and there will continue to be going forward. Many traders are well aware of how powerful these patterns can be. Look for these breakouts. 

Many technicians will place stops just under support to limit losses or establish new short positions. Professional traders know intuitively just where these stops are going to be. There’s nothing sinister about this; they can make an educated guess as to where the stops are just by looking at a price chart, and they look at the same charts as everyone else. 

If a market has held numerous times at 95 and it approaches that level again, what’s to stop professional traders from offering the market down to 94.90. The objective is to uncover the sell stops, and traders can do this on the screen as well as from the pit. A sell stop is a resting order to sell at some predetermined level. If the stops are actually resting at 94.90--they could be held by numerous brokers representing hundreds of traders from various unrelated firms--the selling commences. 

At times, this action can feed on itself. The sell stops at 94.90 immediately begin to work. Remember, a stop is nothing more than a market order to sell at the next price prevailing at the time. The resting orders to buy at 94.90 are filled, so the market is offered lower--94.80, 94.70, 94.60--but everyone seems to be selling---all on stops. The scalpers love this, especially in a quiet or thin market. They’ll come back in and bid at 94.50 and 94.40 and cover their shorts at a quick and tidy profit. Since there was really no fundamental substance behind this price action, the market quickly bounces back above 95 as the shorts are covered and commercial traders and bargain hunters step in. 

As a speculator, getting caught in a false breakout is frustrating. Seeing your stop hit and knock you out of a good position--only to watch the market quickly reverse in the direction you though it was going in the first place--will steam you. All I can tell you is, if you trade long enough, this will happen to you. So keep your cool. Place your stops carefully, where you don’t think everyone else’s stops are. Breakouts from consolidation are such powerful indicators of potential trend changes that you should never become complacent when they occur because, at times, false breakouts exist.  

I’ve developed Six Rules for Trading Breakouts from Consolidation. If you’re interested in receiving my rules at no cost or obligation, shoot me an e-mail: info@commodity.com. Please write “Six Rules” in the subject line, and I’ll make sure that you receive them.

Getting back to our soybean example above, the objective is to be patient, watch for the breakout and then go with it. My bias is the eventual breakout will be to the upside. Just nine weeks into the crop year, the US has already shipped 55 percent of the government’s export projections for the entire crop year, which ends next September. I think it’s impossible for this pace of export sales to continue without pushing prices up eventually. But with that said, the prudent thing to do is put my bias aside and let the market confirm it via an upside breakout from consolidation.

Risk Disclaimer

Futures and futures options can entail a high degree of risk and aren’t appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the "Holy Grail." Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past results aren't necessarily indicative of future results.

Hypothetical Performance

Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading doesn’t involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading.

For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points that can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which can’t be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.

Risk Disclaimer
Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the "Holy Grail." Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.

Hypothetical Performance
Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.