The ability to determine a breakout’s direction after consolidation is completed can give forex traders an edge over the market.

In forex trading, the candlestick pattern known as consolidation occurs when a trend loses momentum. Sometimes momentum is lost due to profit taking, when traders exit the market to lock in their winnings. In this case when action resumes, the trend is likely to continue in the same direction as before, as traders re-enter the market for further profits.

However, at other times momentum is lost when a trend is affected by an economic announcement, or simply runs out of steam. In such a case when forex trading picks up energy again, the trend may reverse direction, sometimes abruptly, and traders who miss the reversal signals, at the very least, will miss the boat.

In either case, the shift in momentum is indicated by shorter candle or heikin ashi bodies, sometimes with long upper and lower wicks, called doji. A number of these doji will cluster together, often in alternating colours, as the market waffles between continuing the trend or reversing it. This pause in the forex trading action is what is meant by a consolidation pattern.

Candlestick technical analysts speak of consolidation as a “battle” between the bears and bulls, with the winning side determining the direction taken by the price when the eventual breakout occurs. As the lost momentum is caused by competing sell and buy orders (supply and demand, respectively), alternately driving the price down then up, the analogy is not a bad one.

The initial glance at a consolidating line of doji generally shows little if any pattern. However, if examined closely, often it can be seen that one of these competing sides has the advantage over the other, visible on the chart as the direction of the longer-term trend (not the day’s trend). Take a look at the chart below:

This is the one-hour chart for the EUR/USD, with red lines highlighting the day’s forex trading that took place on Monday, 4 February 2008. Most of that day’s trading, when viewed on this chart, is little more than doji, with the price fluctuating within a 50-pip range between 1.4793 as support and 1.4842 as resistance.

The five-period moving average price channel (yellow lines enclosing the heikin ashi bars on the chart itself) show the price edging slowly up throughout the day and is definitely lower on the left than on the right. This would seem to indicate that the trend is upward, despite the sharp drop in price on the previous Friday, 1 February.

However, the market base line, which is the thicker yellow line in the indicator window at the bottom of the screen shot, is calculated over greater than 30 periods, a longer period of time than the moving average envelope and therefore a more stable and authoritative indication of the market’s direction. Close examination of the market base line shows that the trend is actually down over the entire graph, with the yellow line above the 50 level at the start of 4 February’s forex trading, and below 50 at the end—a subtle but clear indication of the 180-pip drop on Tuesday, 5 February.