Range trading explained
We look at range trading, and how it can be used to provide opportunities for the times when a market is not displaying a clear trend in any one direction.
What is range trading?
Markets only trend about 30% of the time. This fact presents a problem for traders looking to capture big moves. The rest of the time markets tend to trade in a range, but what does this mean?
A trading range occurs when a market moves consistently between two prices or levels for a definitive period of time. Like trend following, which can be used on any time frame, range trading can be seen in all time frames, from short-term five-minute charts to long-term daily and monthly charts.
Unlike trend following, range trading sees traders going both long and short (at different times) depending on the position of the price within the range. Usually in trend following traders will go with the overall direction of the trend, and buy dips in a rising trend and sell rallies in a falling one.
By contrast, range trading allows a trader to do both, since by definition a price is moving between two clear levels and (on that time frame at least) is making no progress either upward or downward.
How to range trade
Firstly, traders need to identify the range to be traded. Usually, a price must recover from a support area at least twice and also move back from a resistance zone at least twice. Otherwise, the price may simply be establishing a higher low and higher high in an uptrend or a lower high and lower low in a downtrend.
The below shows a trading range – as can be seen the price is moving sideways over time between two clearly defined levels of support and resistance:
The straight lines represent the trading range and provide the trader with the support and resistance zones needed to provide entry points and areas for stop losses and limit orders.
Once the range is identified, the trader looks to enter positions that take advantage of the range. They can either enter positions manually, buying at support and selling at resistance, or use limit orders to enter positions in the appropriate direction once the market has reached resistance or support.
Use of stop losses in trading ranges
As with all types of trading, correct risk management is essential. The principle of range trading sees prices hit a zone of support and areas of resistance. Thus prices will not usually exactly respect these areas; trading ranges tend to attract plenty of traders, and thus volatility could increase. Prices can therefore oscillate around these points, and so prudent traders will look to use wider stops around these key points, and a concurrent decrease in position size to remain within the key 2% rule, in order to avoid ‘whipsaw’ movements that stop out traders from positions that might have ended up being successful trades.
It is important to look at the width of the trading range and also the distances to be employed in stop placement – if the range is too tight then the stops at the required distance may not create the necessary risk-reward ratio, which should be at least 2:1 in favour of risk in order to provide an attractive rationale for a trade.
Using indicators when range trading
Trading a range can just utilise support and resistance levels, but it can also involve the use of indicators. Such technical indicators, such as the Relative Strength Index (RSI), stochastics or the Commodity Channel Index (CCI) can be utilised to confirm the overbought and oversold conditions that often accompany price movements at the top and bottom of a trading range.
The graphic below demonstrates the successful use of the CCI in a range trade:
Trading a range breakout
Of course, no trading range lasts forever. Eventually, all trading ranges end, as the price breaks out, either higher or lower. In this case, the trader can either look to find other markets that are trading, or go with the break out of the range and look to take advantage of the new trend.
The trader may want to wait for a retracement in this trend before placing the trade, in order to avoid ‘chasing’ a market. Buy or sell limit orders could be used in this eventuality, with the order placed so as to take advantage of the breakout.
If a trader is looking to trade a breakout, then other indicators can be used to help identify whether the breakout will continue. A significant increase in volume on a breakout, either higher or lower, would tend to suggest that the change in price action will continue.
Of course, there is always the possibility that a breakout will be a ‘false’ one, and that the price moves back into the pre-existing range. As with all things in markets, without the aid of a crystal ball it is impossible to know when a breakout will continue or whether it will revert. This is why stop losses are essential.
Range trading summed up
Range trading is a useful skill to have. As noted at the beginning, most markets do not trend all of the time. Indeed, trends are relatively rare. Range trading allows traders to take advantage of these non-trending markets. It is not possible to know when a range begins or ends, and thus traders should not try to pre-empt a market, but wait until the range has been established.
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