As a trend follower, you should try to avoid trading during a consolidation. Of course, you will not know whether a market is in a consolidation until after the fact. Sometimes you will find yourself trading in consolidations because of false breakouts. At the time you have no way of knowing for sure where new consolidation areas will form.
Here are some things to look for indicating a new consolidation.
- If the market closing price had retraced more than ½ of the prior up-move (down-move) after a breakout, then the breakout is subject to failure.
- If the market closes back into the consolidation area after a breakout, then the breakout is subject to failure.
- Utilise a closer initial position stop loss trigger to minimise losses in 1 and 2 above. This is discussed in the money management section.
- Look for a trade at the bottom or top of a long and brutal consolidation when and if a new breakout occurs. Your trade should be better because of the previous false breakouts.
Consolidations are difficult to trade. A general rule of thumb to consider is that the better the trend has been, the worse the consolidation will be. People have a tendency to feel fed up with long consolidations and sometimes traders will ignore the next breakout that comes along. This provides a psychological explanation as to why the next breakout may be the one that works.
Exhaustion Rule
The Exhaustion rule is an observation that may be used as a discretionary measure to assist in keeping losses to a minimum and to facilitate trade entry.
This rule is not required to trade the STS system effectively.
The Exhaustion rule applies only to liquid markets and simply stated is
Where a breakout occurs after three or more consecutive higher bars it is prone to a consolidation before continuing.
Thus, if a market starts a breakout with the third or more consecutive higher bar, you may choose to wait for a consolidation to occur prior to entering the trade. If you choose to utilise this tactic you must also utilise the failsafe rule described below.
The Failsafe Rule
Any good trend following system must get you into the market in the direction of the trend. Of course, to participate in the trend, you must be able to enter the market at some point during the move. One of the cornerstones of trend trading is never allowing yourself to make an error by missing one of the few big trends that come along during the trading year.
Therefore you must always be willing to enter a market, buying new highs or selling new lows.
If you do not enter a trade upon an initial breakout, due to a lack of LTT selection or other additional trading criteria, then you automatically get into the trade if the trend continues to the point where the market eventually reaches 2ATR above (below) the breakout point.
This one rule will keep you on the major side of the major trend.