There are only three directions that prices can go. They can go up, down, or sideways. Few traders realize that the most common direction by far, is sideways. Most ‘sideways’ trends are to wide and unstable to play, some are nice patterns that can be played. There is often a great deal of time spent discussing the up and down moves. Yet without education, traders may just give it all back on the sideways moves if not handled properly. We want to review some of the misunderstandings and common mistakes about that ever illusive “sideways” action.

First let’s get some terms straight. For purposes of these discussions, there are many generic terms that describe this sideways action. It may be called a base, a consolidation, or a shelf. It may also be called congestion, a sideways pattern, or just plain aggravating. However, there are only two types of sideways action. They are either a continuation or reversal patterns. Distinguishing these two is not always an easy task, and it involves understanding where you most likely are in the stock (or markets) cycle.

Here is a simple question. Are bases “bullish” or “bearish”? How about a very nice, tight consolidation? Bullish? Bearish? How about the base shown in the chart below?

It is a fact that about 75% of novice traders and even almost half of traders with some experience will say “bullish”. The truth is that bases in general are not bullish or bearish. It depends on what kind of base, and what the surrounding chart pattern is. Bases should be first thought of as continuation patterns, unless proven differently. That means that in the above example, there is a downtrend in place on the bigger time frame, and the tight base formed is likely going to continue lower. See below, the same stock on the 15 minute chart.

This base was simply a continuation pattern. The next morning the stock opened lower, rallied for thirty minutes, and then sold off quickly. One of the ‘clues’ that we need to see for a base to qualify as a reversal base is that the price needs to be very far from the 200 period moving average. On both the five and 15 minute charts, the 200 period moving average is near the price. This makes it more likely than not that a continuation pattern was all that developed.

When in an uptrend, the same concept applies. Tight bases, on reduced volume, should be first thought of as continuation patterns to take the stock higher. Below is an example of a continuation in an uptrend.

Most traders do not have any problem saying that this price goes higher. Most traders have a bullish bias. While both of the above stocks are the same types of consolidations and both should continue the price action that was in place (lower for the first stock, higher for the second), almost twice as many traders will say higher for the second as say lower for the first. Traders like to be bullish. Remember, “the trend is your friend” is the first rule of trading. Do not assume bases in downtrends are going to reverse a stock any more than bases in an uptrend will reverse a stock.

Now, that being said, all bases are not the same. Some bases do reverse price action and complete the stock’s cycle. They are called reversal bases. There are certain characteristics of bases that tend to lead to reversals and changes in trend. Have you ever played base breakouts and found they worked great for a while, then they all started failing? That is because some bases are made to ‘stay in” the base. There is also a fail-safe way of telling the difference. Knowing this difference would save many traders from a great number of the failures that occur when playing bases. We will look at some of these in the next lesson.