Summary - One of the keys to investment success is the ability to make money in any market. One of the ways to do that is to understand the principles of range trading. Traders rely on daily charts to track the movement of securities. When they see a predictable stair-step pattern, it tells them the trend that it is occurring with that security. Trend traders look at nothing but the trend. Whether in a bull market or bear market, the trend is their guide. However, trends are only present a small percentage of the time. The majority of the time, stocks, currency pairs, and futures move in a price range. This range is marked by a line of support that set a price floor and a line of resistance that sets a price ceiling. Although this range can be narrow or large, once investors find a true range they can use predictable market movement lead them to profitable trades.
Range traders rely on technical indicators and other trading indicators such as Bollinger bands and stochastic indicators to assess the volatility and momentum surrounding the price movement. Range trading works when the movement is somewhat predictable and the range is not showing a lot of contraction or expansion. When there is increased trading volume and price extremes occurring, it is typically a good indication that the underlying security is about to break out of its range. The use of protective stops can protect an investor regardless of the direction of the new trend.
No security moves in one direction all the time. When considering an investment, traders love to see definitive trends that show upside or downside movement, for many traders, there is a huge potential for profit when a security trades in a specific range. This article will provide an overview of range trading that includes discussing why range trading is significant, popular range trading strategies, the kind of technical indicators that are used in range trading. We’ll also review what makes range trading a viable strategy and the risks involved in range trading.
What is range trading?
Range trading is a trading strategy based on technical analysis of price movement between a defined level of support and resistance. In the case of a trading range, the bottom of the range indicates a level of support and the top of the range indicates an area of resistance. Range trading involves selling as prices move towards defined resistance levels and buying when prices approach defined levels of support.
Range trading can be conducted for almost any security. When used in the foreign exchange (Forex) market, the price points are measured as pips. One pip represents the smallest movement a currency pair can make.
Why are trading ranges significant?
Investors want to profit by trading with the trends. Trend traders look for periods when securities show defined price movement that is marked by a pattern resembling a series of steps. In the case of an uptrend, that pattern will be marked by higher highs and higher lows. In the case of a downtrend, it will be marked by lower highs and lower lows. These price movements are also defined by easily identifiable impulsive (stronger, more price movement) and corrective (weaker, less price movement) moves.
However, securities only display a defined trend for a fraction of the time. More commonly, they trade in a tight range because buyers and sellers are relatively equal keeping the price within a tight range. This price consolidation, in some cases, indicates that a reversal of the previous trend is about to occur. However, in other cases, a trading range may indicate a pause where the market is consolidating (taking a breath) before continuing in the direction of the trend.
That being said, in most cases, it may take some time before there is enough momentum to cause a breakout (securities move above a resistance level) or breakdown (securities move below a support level). Therefore, understanding how to effectively execute a range trading strategy can be essential to making money regardless of the market conditions.
What are the popular range trading strategies?
One of the most common strategies for range trading is to simply trade against support and resistance. This strategy starts by identifying a security that is trading within an established range. Identifying a range is essential to this strategy. This is done by charting a price that moves between at least two similar highs and lows without breaking above or below those points at any point in between. Why two? Frequently a price may start to rise or fall and take out a high or low. Once a trading range has been identified, traders can look at tools such as the relative strength index (RSI), a stochastic oscillator or the commodity channel index (CCI) to confirm whether movement within the trading range correlates with an overbought or oversold market. Even though a security is trading within a range, it does not mean that is a tight range. In some cases, there may be significant price movement between a level of support and resistance.
Options traders frequently use this strategy by buying a call option near support levels or selling put options near levels or resistance. More experienced traders may use more sophisticated strategies to simultaneously trade on both ends of the trading range.
Another strategy involves trading on breakouts and breakdowns. A breakout occurs when a security breaks out above its trading range. The converse term is called a breakdown which occurs when a security breaks below its trading range. In this scenario, instead of trading within the range, they wait to execute trades until a security has a breakout or breakdown from the range. One way to identify opportunities for this kind of trade is to look for securities that have been bound within a range for a long time. The longer a security stays bound within a range, the more likely it will be that a breakout or breakdown will occur. However, what is considered a long time is based on your frame of reference. For example, day traders look for short-term price movement and seek out securities that break above or below their opening trading range within the first half-hour of trading.
However, the goal of this strategy is to capitalize on price movement that indicates an adjustment to a defined support or resistance level. This is because a security may breach a support or resistance level without being ready for a breakout or breakdown. Instead, there can be other explanations including stopping or reversing. To confirm that a new trend is emerging, traders will look for other indicators such as increased volume or more volatile pricing action because this indicates that traders and investors have a high degree of interest to buy and sell that particular security.
Another popular trading strategy used by successful traders is known as trading the gap. A gap is a period marked by sharp price movement up or down with no trading in-between. Gaps frequently occur because of overnight and pre-market trading that may be spurred by a positive or negative earnings report. A gap is common in forex trading.
What are some other range trading indicators?
There are several different trading indicators that traders can use both to identify a range and also to check for the strength of price movement, which can be an indicator that price is picking up momentum in a specific direction.
Bollinger bands– show expansion or contraction of prices over a period of time. To create a Bollinger band on a stock chart, a centerline is created using an exponential moving average. After that price channels (or bands) are created by calculating one standard deviation above and one below the center line. The upper and lower bands become your price targets. If prices continually touch the upper band, it's an indication that the stock is overbought. Conversely, prices that continually touch the lower band indicate that it may be oversold.
Relative strength index (RSI)– this is a simple calculation that measures the magnitude of recent price changes to track momentum that may indicate when stocks are overbought or oversold. The calculation of the relative strength index is as follows:
RSI = 100 – 100/(1 + RS)
RS = the average gain of up periods during the time frame being measured divided by the average loss of down periods during the time frame being measured. RSI is usually calculated over 14 trading days.
An RSI can range from 0 to 100. An RSI at or above 70 usually indicates an overbought condition. An RSI of 30 or below usually indicates an oversold condition.
Fibonacci retracements– are technical indicators that help traders identify strategic points to make transactions, set target prices or assign stop losses. Fibonacci retracement levels are created by placing horizontal lines at areas where a price meets support or resistance at key Fibonacci levels before continuing in its original direction. These levels are created by plotting a trend line between a major peak and trough, then dividing the distance between the two by the following ratios (called Fibonacci ratios): 23.6%, 38.2%, 50%, 61%, and 100%.
Fibonacci retracements are static prices that do not change, unlike moving averages. Because they are static, traders get prudent guidance that allows them to react to a price change.
Stochastic oscillators– are momentum indicators that compare a stock's closing price to its range of prices during the time frame being measured. The premise behind stochastic oscillators is that closing prices will tend to reflect market trends. So if the market is trending positive, an individual stock will generally close near its daily high, and if the market is trending lower, a stock will close near its daily low. The oscillator is range bound, however, its sensitivity to market movements can be reduced by adjusting either the time period or by calculating a moving average of the result.
Average Directional Index (ADX)– This is another kind of oscillator that behaves similarly to the RSI. The ADX can register from 0 to 100 with any reading below 20 indicating a weak trend and any reading above 50 indicating a strong trend. The ADX does not provide an indication of price direction (uptrend or downtrend) only that there is growing momentum.
What makes range trading a viable strategy?
As we mentioned above, a trading range will display clear extremes on both ends. This makes it very easy for traders to know where to trade. Once a price moves to one of these extremes it will do one of three things:
- Breakout or breakdown
The extremes represent areas of support and resistance. Support and resistance areas will be areas that generate a lot of trading activity. The key questions for traders are what type of price movement (rejection) are they looking for and where will they place their stops. Stops are an integral part of a range trading strategy and should be set according to a trader’s risk assessment.
What are the risks of range trading?
In life, we like the axiom of "if at first, you don't succeed". In investing, traders often look at times when a security tests its 200-day moving average or a 52-week high or low as a signal that it's ready to make a large move. However, when it comes to range trading, multiple tests of a support or resistance level do not always indicate that a breakout or breakdown is going to emerge. However, in some cases, prices will push above a resistance level only to pullback or fall below a support level only to bounce up. These are known as expanding or converging ranges and when they happen frequently it can increase the risk profile of a trade.
The final word on range trading
For most investors, the most profitable time to trade is when securities are trading within a range. While it is important to understand when, and if, a particular security is an uptrend or downtrend, the majority of the time a security’s price movement will occur within a specific range. As an investor, understanding how to trade within this range can be a profitable opportunity.
Ranges can be narrow or large. However, one of the keys to successful range trading is stability. If a range continues to expand or converge, it typically indicates indecisiveness by investors. As a trader, this can increase the risk profile. This makes knowing where to place trading stops an integral part of a range trading strategy.
One caution in regard to range trading is that ranges will end. The longer a security has been locked in a range, the more likely it is to be ready to breakout or breakdown. For this reason, traders should pay attention to not only price movement, but also trading volume and more volatile price action as indicators of growing intention to buy or sell.