Today we are going to discuss how price action reacts in congestion. Congestion is a tricky thing, but when trying to understand congestion, a trader mus think trading range, and apply our trading range rules as we teach them in our price action trading manual. If you haven’t already read any of our articles on trading ranges, then you might start with them, because at the end of the day, congestion is nothing more than a small trading range, so the rules work exactly the same as they do with any other trading range. We actually have several articles that talk about how we trade ranges, so you can find more than ample materials here on our web site that discuss this topic. In order to simplify your search, here is a direct link to a really good article on trading ranges. Take a few minutes to click over and read it first, then come back and read the rest of this article.
What I find really interesting is that when I search the Internet for information on how to trade ranges or congestion, what I find is that most strategies are teaching trader’s to buy on a break higher out of a range, or sell on a break lower out of a range. This is concerning for me, because experience proves that this is the exact opposite of what one must do when trading most ranges or congestion areas, particularly in the stock indexes like the ES, YM, NQ or RF, which are the most popular index futures amongst day traders. What actually happens is that most initial break outs fail, regardless of the direction of the breakout. We have and teach some very specific rules on how to trade these break outs, and they serve us well, but very few others understand our rules, and what you are reading and being taught in most cases is just completely wrong. Buying and selling on a break out of congestion will fail the majority of the time, and while you will occasionally see a big move on a break out of ranges and congestion, it will happen only often enough to keep you trying it, and in the end, you will go broke. This I can assure you, and later on I will show you this in real time on some of my charts.
As an example, I did a Google search on “day trading congestion” and I found a list of sites that talk about how to trade ranges or congestion and guess what? Almost all of them suggest buying on a break out of the range. Below is one example I found at www.thepatternsite.com. It’s not my intent to pick on this site, but the fact of the matter is that the site is considered an authority site by Google, yet they are teaching you something that will certainly create losses for you if you day trade the ES or any of the other stock indexes. Here is a small excerpt from that website and what they teach about trading ranges and congestion.
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In this example, the breakout occurs at candle A, and price makes a strong move up. This straight-line uptrend does not occur every time, so your situation will vary. As price rises move your stop higher using the low price of the prior candle (a penny or two below the bottom of the candle. If you place it at the low price instead of a penny or two below, you will be stopped out when a tweezers candle appears. Avoid that by using a stop placed 1 to 2 cents below the low). Raise the stop as each new candle appears. For choppy price movements, perhaps a stop below the lower of the prior two candles would work better.
Try to give price room to move higher without the trade being stopped out. Another exit method is to use a 10 period exponential moving average, but you may find that the candle low stop method works better. The EMA tends to hug the price trend as the stock rises. When price pierces the EMA, then close out your position.
Using a stop a penny below the prior candle low (placed at B) takes us out at candle E, as the figure shows. You can read the rest of the original article here.
What is really interesting, is that the author actually clarifies that “this straight-line uptrend does not occur every time, so your situation will vary.” He’s actually admitting that it doesn’t always look as pretty as his example. Again, my intent is not to embarrass or negate anything that this website is teaching. I will also clarify that the author is not alone in what he is teaching, because I see it all over the Internet and I used to trade this way myself before I became a profitable trader. It’s really nothing more than a lack of understanding about how price action actually works. I will also clarify that prices do indeed break out strongly from time to time, but there is almost always a signal of when to enter, after the break out, and even then, there are some very specific rules that will guide you and help you determine if the break out will succeed, or if it will fail. This is the beauty of price action trading, and once you understand that there are very specific rules that prices follow the majority of the time, you will then come to appreciate what we are teaching here at PATs! Nothing is ever 100% in trading, but when you can find a bias that works the majority of the time, you can use that bias to profit as a trader.
So what should a trader expect to happen around trading ranges or congestion? In most cases, prices will find resistance at the highs and turn down, or support at the lows and turn up. If there is room to profit between the highs and lows, then you can use this knowledge to make easy money when trading ranges and congestion. Ranges and congestion are very difficult for most traders, but if you understand the rules as we teach them here, then they become extremely predictable and easy to trade. Obviously congestion will not have room to trade between the highs and lows, because congestion is usually a range that just consists of overlapping bars, so don’t try and trade between the highs and lows of congestion.
If and when prices do break out of ranges or congestion, the rules tell us that they will usually fail and pull back again. It’s really common to see prices break out one side and fail, then move to the other side of the range and break out and fail, only to pull back and test the former low or high of the range, then start trending in the direction of the break out. In other words, the breakout will normally not take off strongly, but will more often break out a few ticks or a couple of bars, then immediately pull back and look for support at the high of the range or resistance at the lower side of the range first. If prices indeed find support or resistance, then they are more likely to continue trending in the direction of the break out. If you understand these tendencies, then ranges or congestion areas suddenly become an entirely new trading game with the odds stacked heavily in your favor for understanding where prices are likely going next. In fact, if you could see the picture that accompanied the example of the trade that we talked about earlier above that showed a successful break out, you would actually see that prices broke out the lower side of the range first by a single tick and failed, only to reverse and go out the upper side, so even that example shows positively why you don’t buy and sell on break outs.
We hope that what we have discussed here has been helpful and that you now have a much better understanding of how price action reacts in congestion, which is basically the very same way as how prices react in a trading range. Below is a short video that will show you some examples of what I’m referring to here, as it’s often difficult to put this information into easy to understand wording. If you are interested in learning more about how we use price action and our price action trading rules, you can find that information at http://priceactiontradingsystem.com/pats-price-action-trading-manual.