Traders can get hung up on trends – the fact is that most of the time market is not in a strong up or down trend; it is moving sideways (although this is itself a trend of sorts). When markets are fluctuating up and down with no strong direction, trading the range can be a useful approach, particularly for intra-day forex traders hoping to profit from short-term volatility in prices.
Traders seek to identify overbought and oversold extremes – resistance and support areas, buying when the market is oversold and selling when it is overbought. Ranges, it may be said, are often corrective waves within a stronger trend with the direction of the price flattening out and holding within a range while the longer term trend pauses for breath. Alternatively, strong trends can simply run out of steam and prices can start to fade sideways for a period of time until new information is available to reignite the trend or spark a reversal and a new trend in the opposite direction.
The basis of trading a range is to identify when prices are reaching an extreme within the range and are due to reverse course in the other direction. In many ways, therefore, trading ranges is about spotting short-term trends and reversals. Many range traders are not fussed about direction – their view is that prices will tend to trade through a particular level more than once or multiple times and therefore will seek to profit from this oscillation around a mean.
The importance of Support and Resistance
The most important aspect of trading ranges is being able to identify the upper and lower price bounds – in other words, we need to identify the range.
We can do this by identifying highs and lows to create support and resistance levels. For instance, on the below chart we can see a clear trading range for the EURGBP pair from September 2017 to March 2018 with prices moving within the c87-90 range without any clear evidence of direction.
An example of the EURGBP stuck within the 87-90 range.
To identify the range, we can look for multiple touches (at least 2) on the lower and upper bands – the levels of support and resistance. These need not be precise and may be classed as zones of support and resistance.
Moving Averages and Mean Reversion
If one views prices changes as a distribution around their average, then it stands to reason that they will have a tendency to revert to the mean. Moving averages play an important part in range trading by showing where this mean price is and therefore highlighting how far price action is moving away from the mean. The idea of range trading is that when prices do move a long way from their average, there is a solid chance that they will in part at least try to move back to the average, or mean. If markets are in a strong uptrend, they will tend to be above moving averages; and below if in a downtrend.
In a sideways market such as this example of gold (below chart), the price action oscillates intermittently on either side of the 50-day moving average.
An example of Gold (XAU/USD) hugging its 50-day moving average.
With our range identified, we can start to consider entry and exit points for our trades. The use of indicators and oscillators is important here. The aim, of course, is to enter when the market approaches one extreme of the range, and exit once it reaches the other. Determining when a market is overbought or oversold is clearly very important. Various indicators can be used to help. For instance, the Relative Strength Index and Commodity Channel Index (CCI) are indicators that may be used as these delineate prescribed overbought and oversold levels.
There are different ways to approach a range trade. You can use established levels of support and resistance, incorporate indicators and oscillators, and/or make use of moving averages. There is no hard and fast rule, but considering the various elements and knowing how and where to apply each –and when not to – is important. In a simple range-bound market, the idea would be to place a buy order just on or just above established support or enter when the price is considered oversold and is below the moving average. A stop loss order can be placed below the support level or somewhere below the entry point. The take-profit (limit) sell order can be set on or near the level of established resistance, or near where the moving is. As ever with trading, having a clear risk to reward ratio in mind is important. Usually, traders will look for this to be something like 1:2, or 1:3.
Managing risk – spotting breakouts
We have just touched on stops, but these are very important. Breakouts can occur and so a stop can protect your trade from running higher losses. However, many false breakouts are common in range-bound markets and therefore it is important to pay close attention to how far your stop is away from the entry point. In this regard, the importance of thinking about support and resistance as zones rather than precise price points is useful as it can allow for many false moves. By the very nature of range trading, you are at risk of a breakout leading to losses. Looking for breakout patterns on price charts plays an important part, while indicators and oscillators will also help identify when a breakout might happen. For example, when Bollinger Bands narrow it is usually a sign of a very sharp price move – something that you should beware when trading a relatively narrow range.
This article was written by ETX Capital