A congestion level is an area on a chart where the market trades a substantial amount of volume within a compressed area. While not a defined pattern with implicit predictive implications, congestion levels are interesting for technical traders as they represent the creation of vested interest at or around a price level. Any rapid move away from that level will create winning and losing positions, which the winners will want to keep and the losers will be desperate to unwind. Congestion levels are particularly interesting in markets with low intraday liquidity, where a temporary surge of participant enthusiasm can create a volume of new positions that cannot easily be unwound without moving prices sharply higher or lower.
Consider the following tick chart, which depicts 500 individual trades:
Figure 4.19 Congestion levels in tick data.
The first 234 trades on the chart are clustered between $99.30 and $102.15. As soon as the market breaks below $99.30 there are 234 winning short trades and 234 losing long positions. While not all losing traders will immediately seek to exit their position, many certainly will. If the market makes a low volume move away from the congestion level it may be difficult for the losing traders to exit, which will continue to drive the market lower. This type of self-perpetuating market move is sometimes called a “rolling stop-loss,” where the actions of traders closing out positions push other traders past their point of comfort, motivating additional buying or selling. It can be very beneficial for traders to monitor the volume accumulated during a congestion formation, as even a rough estimate can provide a sense of the losing positions that will need to be unwound and give some perspective on the potential magnitude and duration of any buying/selling motivation.
From Chapter 4 - Technical Analysis, Pages 138-139.
Excerpt from Trader Construction Kit Copyright © 2016 Joel Rubano. All rights reserved. No part may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by reviewers, who may quote brief passages in a review.