Identifying Consolidation Area Call Put Strategy

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In our binary options education series, we have explored the area of technical analysis or charting quite extensively. In today’s article, we will be looking at identifying consolidation areas, which are basically areas of market indecision where prices are consolidating; typically right after sharp price movements as markets ‘absorb’ the information that caused the price movement in the first place. A consolidation area is also part of a continuation pattern; the price movement before the consolidation area and after the consolidation area will tend to move in the same direction. Obviously, being able to identify such areas would be a great trading advantage.

We will be looking at 2 strategies for identifying consolidation areas today: the Ichimoku Kinko Hyo and the Head and Shoulders consolidation pattern.

Ichimoku Kinko Hyo

A charting technique developed by a Japanese journalist in the 60s, the term loosely translates to “one look equilibrium chart”. This chart consists of 5 different lines, elaborated on below:

  • Conversion Line – The Tenkan-sen is calculated by the average of an asset’s 9-period high and 9-period low.
  • Base Line – The Kinjan-sen is calculated by the average of an asset’s 26-period high and 26-period low.
  • Leading Span A – The Senkou Span A is the midpoint between the conversion and baseline. It also forms one of the boundaries of the Ichimoku Cloud and is plotted 26 periods in the future.
  • Leading Span B – The Senkou Span B is calculated by the average of an asset’s 52-period high and 52-period low; it is also one of the boundaries of the Ichimoku Cloud and is plotted 26 periods in the future.
  • Lagging Span – The closing price of an asset plotted 26-periods in the past.

The graph above gives an example of an Ichimoku Kinko Hyo chart. Pay attention to the red and green shaded areas, those are the Ichimoku Clouds mentioned above. When the Leading Span A is above the Leading Span B, it is a green cloud and when the Leading Span B is above the Leading Span A, it is a red cloud.

The cloud is the main tool used to analyze trends in this method; when prices are trading above the cloud, it is an uptrend and when prices are below the cloud, it is a downtrend. Because of this, the clouds themselves form a support or resistance level; look at the 2 examples below for indications of cloud support and resistance. In addition, because the boundaries of cloud are plotted in the future, when the cloud changes color it can be used as a sign of future resistance levels.

Within the larger uptrend or downward determined by whether prices are trading above or below the cloud, the relationship between the conversion line and baseline as well as the relationship between the price and the baseline can also act as smaller ‘signals’ within the larger trend. When the conversion line moves above the baseline within an uptrend (green cloud) or below the baseline in a downtrend (red cloud) those are examples of smaller bullish/bearish signals within an uptrend/downtrend. Also the price moving above or below the baseline during an uptrend/downtrend is another indicator of smaller bullish and bearish signals within their respective trends.

And now that we understand how to read an Ichimoku chart, how do we identify consolidation areas? Simple, the idea behind a consolidation area in a chart above can be summarized in one word: convergence. When you identify an area on the chart where the price, the cloud, the base line, and conversion line are all converging, then we have a consolidation area. Check out the example below:

Notice the convergence of the price, cloud, conversion line and base line which form a consolidation area. Next question is how do we know when the consolidation period is over? Look at the area to the right of the highlighted rectangles in the examples above: see how there are candles that fall below the conversion line without touching it? That’s a sign the consolidation period is over and also represents a trading opportunity. And since consolidation areas are continuation patterns; in the examples above since the preceding trend was a downtrend; the move here would be to place put options right after the consolidation area.

Now, let’s talk about timeframes. Remember that charting is not 100% accurate and some patterns are weaker than others. As a general rule, the longer the timeframe of a consolidation area, the stronger a predictor it is.

Consolidation Head and Shoulders

In our brief intro on binary options charts, we mentioned that the Head and Shoulders pattern is a reversal pattern; meaning that after the pattern is complete the trend that follows is generally the opposite of the trend that preceded the pattern. However, there are some Head and Shoulders patterns that are consolidation patterns instead of reversal ones. Look at both examples below:

The first chart shows the traditional reversal Head and Shoulders pattern while the second shows the consolidation Head and Shoulders pattern. How do we tell the difference?

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We tell the difference by comparing the preceding trend to the Head and Shoulders pattern with the shape of the Head and Shoulders pattern itself. In a typical reversal Head and Shoulders pattern, an uptrend will be succeeded by a Head and Shoulders Top pattern (as seen in the first chart) and a downtrend will be succeeded by a Head and Shoulder Bottom or Inverse Head and Shoulders pattern.

Conversely, take a look at the rarer consolidation Head and Shoulders Pattern; the preceding downtrend is followed by a Head and Shoulders Top pattern, indicating a continuation or consolidation, instead of an Inverse Head and Shoulders, which would typify the regular reversal Head and Shoulders.

Identifying Consolidation Area: Call Put Strategy

What Consolidation Area is?

A consolidation area is an area that has more than two support/resistance levels in the same place or almost at the same place.

A consolidation area is also part of a continuation pattern; the price movement before the consolidation area and after the consolidation area will tend to move in the same direction.

Ways of Identifying Consolidation Areas

There are few universal ways to Identifying Consolidation Areas. Lets discuss some of the ways below.

Ichimoku Kinko Hyo:

It’s one of the unique and the easiest way of Identifying Consolidation Areas.

This charting technique was developed by a Japanese journalist in the early 60s.

Ichimoku Signals or elements are considered vital in the context of overall chart.

Ichimoku Kinko Hyo is a visual technical analysis system that combines all its elements and builds a relationship, including the price.

The term loosely translates to “one look equilibrium chart”.

There are five different lines in this technique.

  1. Tenkan-sen: It’s a conversion line that is calculated by the average of an asset’s 9-period high and 9-period low.
  2. The Kinjan-sen:The Base line is calculated by the average of an asset’s 26-period high and 26-period low.
  3. The Senkou Span A: The Leading Span A is the midpoint between the conversion and baseline.
  4. The Senkou Span B: The Leading Span B is calculated by the averageof an asset’s 52-period high and 52-period low; it is also one of the boundaries of the Ichimoku Cloud and is plotted 26 periods in the future.
  5. Lagging Span :The closing price of an asset plotted 26-periods in the past.

The graph above gives an example of an Ichimoku Kinko Hyo chart.

Pay attention to the red and green shaded areas, those are the Ichimoku Clouds mentioned above.

When the Leading Span A is above the Leading Span B, it is a green cloud and when the Leading Span B is above the Leading Span A, it is a red cloud.

The cloud is the main tool used to analyze trends in this method; when prices are trading above the cloud, it is an uptrend and when prices are below the cloud, it is a downtrend.

Because of this, the clouds themselves form a support or resistance level; look at the 2 examples below for indications of cloud support and resistance.

In addition, because the boundaries of cloud are plotted in the future, when the cloud changes color it can be used as a sign of future resistance levels.

Within the larger uptrend or downward determined by whether prices are trading above or below the cloud, the relationship between the conversion line and baseline as well as the relationship between the price and the baseline can also act as smaller ‘signals’ within the larger trend.

When the conversion line moves above the baseline within an uptrend (green cloud) or below the baseline in a downtrend (red cloud) those are examples of smaller bullish/bearish signals within an uptrend/downtrend.

Also the price moving above or below the baseline during an uptrend/downtrend is another indicator of smaller bullish and bearish signals within their respective trends.

Consolidation Head and Shoulders

The Consolidation Head & Shoulder Pattern is a reversal pattern.

It both of the consolidation and the reversal variety.

This pattern is considered of two shoulders and a spike higher or lower that is called the head of the pattern.

There are some Head and Shoulders patterns that are consolidation patterns instead of reversal ones.

Look at both examples below:

The first chart shows the traditional reversal Head and Shoulders pattern while the second shows the consolidation Head and Shoulders pattern.

By comparing the preceding trend to the Head and Shoulders pattern with the shape of the Head and Shoulders pattern itself we can tell the difference.

In a typical reversal Head and Shoulders pattern, an uptrend will be succeeded by a Head and Shoulders Top pattern (as seen in the first chart) and a downtrend will be succeeded by a Head and Shoulder Bottom or Inverse Head and Shoulders pattern.

Use the Right Time Frame

Use of right time frame is another way of identifying consolidation area.

The bigger the time frame, the stronger the support and resistance is.

The opposite is true as well, as the lower the time frame, the easier for the area to be invalidated.

If the time frame of consolidation area is a short one then the expiration dates for the traded options should be smaller as well.

Again, if the consolidation area is to be found on the bigger time frames, like the daily, four hours’ chart or even weekly, we need to adjust the expiration date accordingly.

The best way to identify consolidation areas, by trading with moving averages and the way to go is to plot on the chart different moving averages, exponential ones or simple ones, with values from 20, 50, 100 and 200.

Elliott Waves Theory

Elliott Waves Theory means looking at patterns that happened on the left side of the chart and trying to project or to forecast the next move on the right side of the chart.

Therefore, knowing those patterns is vital key for what to look for on the right side of the chart.

Such patterns are most likely to be triangles as they represent the favorite way market is consolidating and triangles can be contracting and expanding.

It is difficult to properly identify a triangular formation on the smaller time frames, but can be done on the bigger ones.

For example, complex corrections are almost always ending with a triangle so by the time the triangle is breaking its b-d trend line it means the correction is completed and most likely an impulsive move should follow.

If the correction was bullish, then put options should be traded as the move to follow should be a bearish impulsive move, and of course if the correction was bearish, then call options should be traded as the move to follow should be a bullish impulsive move.

Moving forward and knowing an impulsive move coming, then the most common impulsive move is the one that has the third wave being the longest so waiting for waves one and two to complete before buying an option to meet the third wave requirements should be key.

In this case, because third waves represent fast moves, short-term expiration dates can be traded.

The theory of Elliott Wave: Mr Elliot said that in a trending market, price moves in a 5-3 wave pattern.And in this 5-3 wave pattern, there are two types of waves:

  1. the first wave pattern is called the impulse wave
  2. the second wave pattern is called the corrective wave.

Elliott wave theory allows the trader to divide the market into cycles and super-cycles and this allows for counting the waves.

Impulsive moves are always being labeled with numbers (1-2-3-4-5) while corrective waves are always being labeled with letters (a-b-c).

The most common corrective waves are flats, zigzags and triangles, but on complex corrections market is making combinations of those simple corrections and the result may be a double or triple flat, a double or triple zigzag, triple or double combination, etc.

So, above options can be used for identifying consolidation strategies based on patterns and based on indications.

From above discussion we can come to the point that head & shoulder patterns are mosty used and the easiest way to identify the consolidation areas.

Identifying consolidation areas – call and put strategy

Defining a Consolidation Line

Before even moving into discussing consolidation area, there’s the need for defining what a consolidation area is. Such an area is defined to be any area that has more than two support/resistance levels in the same place or almost in the same place.

In our case, we’re going to use the Ichimoku Kinko Hyo to identify consolidation area and one way to trade binary options is to look for the cloud, the Kinjun and Tenkan to come into the same place and this would be really difficult for market to overcome.

The second example we’re going to cover here is based on moving averages and trading with multiple moving averages can give you an idea about where a consolidation area can be found.

Use the Right Time Frame

But above all, there is one particular factor that is almost always overlook by market participants: the time frame element. The whole purpose of identifying a consolidation area is to look for it to act as a support/resistance for price. As a rule of thumb, the bigger the time frame, the stronger the support and resistance is. The opposite is true as well, as the lower the time frame, the more easier for the area to be invalidated.

Consolidation areas, or ranges, are extremely valuable to any trader and it depends very much on the time frames the ranges are forming. This is important as if the time frame is a short one, like one minute or the five minutes charts, then the expiration dates for the traded options should be smaller as well. On the other hand, if the consolidation area is to be found on the bigger time frames, like the daily, four hours chart or even weekly, we need to adjust the expiration date accordingly.

Consolidation areas can be found by trading with moving averages and the way to go is to plot on the chart different moving averages, exponential ones or simple ones, with values from 20, 50, 100 and 200. This means that these averages will take into consideration different periods back in time to plot the values and a confluence area appears when the averages are crossing and are to be found in the same place. That area is difficult to be broken by price and therefore, in a bearish trend, when price is reaching that area, put options should be traded, while in a bullish trend any dip into such an area is considered to be a place to buy call options.

Ranges are wonderful to be traded with oscillators as we all know that oscillators are showing overbought and oversold levels. If the range is a triangle that is forming on the bigger time frames, then going on the lower time frames and trading call options on any move of the oscillator in the oversold territory and put options on any move in overbought territory is key.

Consolidations with Elliott Waves Theory

If one is using the Elliott Waves Theory to analyze markets before taking a trading decision then looking for second and fourth waves is key. However, there’s a catch in the sense that consolidation areas are to be found mostly on complex correction and not in simple ones. That being said, principle of alternation is coming in handy in the sense that if the second wave for example is a simple correction, then chances are that the fourth wave is going to be a complex one, so ranges can be traded on the fourth wave that is about to come.

Still with the Elliott Waves Theory, when complex corrections are forming on the bigger time frames, look for X waves to intervene and this means put options in overbought territory as well as call options in oversold.

Whenever a range is identified, binary options can be traded and this opens the gates not only for classical high/low trading, but also for boundary and one touch. The idea is for the one touch option for example to buy a one touch in the oversold or overbought territory shown by an oscillator. If that oscillator is the RSI (Relative Strength Index), then buying the options on any move price is making towards the 70 or 30 level should do the trick.

Use Classical Patterns

Last but not least, classical technical analysis patterns can be used and one of them that lets us identify a range is the head and shoulders.

It is known that a head and shoulders pattern is formed out of two shoulders and a spike higher or lower that is called the head of the pattern. The idea is that most of the times the right shoulder is looking similar with the left one and therefore we can have a place to buy put options based on the higher values on the left shoulder and call options based on the lower values of the left shoulder.

However, the amount to be invested should be always bigger on the options that go with the general direction the pattern is about to break.

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