Placing price action into a manageable context is an essential part of crafting strong trading decisions. To accomplish this task, many traders rely upon technical analysis. Through the study of past and present price action, technicians can build strategies designed to capitalise on favourable market conditions. Range trading is an exceedingly popular category of such strategies.
Market structure comes in two basic forms: trending and range bound. Trending markets are those in the process of making a directional move in price. Conversely, range bound markets consistently trade between a periodic high and low value. Although many traders favour trend strategies because realizing extraordinary returns is possible, range bound markets also offer countless opportunities.
What Is A Trading Range?
A trading range develops when price is confined between a periodic high and low value for a given period of time. Various factors influence the size and extent of a market's trading range; uncertainty, market participation, support & resistance levels and assorted fundamentals are several of the most prominent.
To illustrate the trading range concept, assume that Erin the euro trader is observing daily forex price action for the EUR/USD. Over the course of a given month, the following scenario establishes a trading range in the EUR/USD:
- The EUR/USD opens the month at 1.2055.
- Within the first two weeks, exchange rates post a low of 1.1865.
- The EUR/USD trades between 1.2055 and 1.1865 until the month's end.
In the example above, the EUR/USD's monthly trading range falls between 1.2055 and 1.1865. Of course, this information may or may not be strategically useful. There are many questions that Erin must answer before determining if the EUR/USD's price action is that of a trending or range bound market. Below are three important inquiries:
- Is the monthly trading range unique in comparison to previous months or to established norms?
- Did price test each extreme multiple times or did price consolidate around a mean value?
- Within the range, where did the bulk of the trading volume occur?
It's important to remember that not all trading ranges are significant. Every market establishes periodic highs and lows ― the key to determining whether a market is trending or range bound lies within the structure of its periodic range.
Trading Range Bound Markets
From a practical standpoint, range bound markets may occur on any timeframe or interval, in any asset class. For active practitioners of technical analysis, referencing a pricing chart is the first step necessary for identifying and interpreting a trading range.
There are two essential elements of any trading range:
Periodicity: The periodicity of a trading range refers to the selected interval of its pricing chart. Ranges may be identified on all time-based intervals, from minute-by-minute to yearly. Data-based tick and volume charts may also be used.
Volatility: As a general rule, the larger a market's periodic trading range, the greater its volatility. Extraordinarily large ranges are indicative of markets that are, or have been, trending. On the other hand, modest-sized or small periodic ranges suggest range bound conditions. When in this state, a market is said to be ranging, consolidating, trading sideways, or compressed.
Although legions of traders choose to specialise in trend trading strategies, range bound products also provide an array of opportunities. Consolidating or compressed markets offer a distinct structure, conducive to the application of many strategies. In fact, breakout traders and trend traders often interpret consolidating markets to mean that a directional move is forthcoming. However, one of the most popular methodologies for trading range bound markets is known as reversion-to-the-mean.
A reversion-to-the-mean strategy is one way that active traders attempt to profit from range bound markets. Within the confines of this approach, the range's periodic top is viewed as viable resistance; the bottom acts as support.
To execute a reversion-to-the-mean trade, one sells from the upper extreme and buys from the lower extreme. Subsequent profit targets are modest, set toward the average or median value of the trading range. Protective stop losses are placed outside of the range to protect against an unforeseen breakout.
Once again, assume that Erin the euro trader is watching the EUR/USD, but this time on a 4-hour chart. Rates of the EUR/USD have become compressed, posting a 24-hour high of 1.2215 and low of 1.2175. Erin chooses to execute a reversion-to-the-mean strategy to trade the compressed market conditions:
- Erin enters a sell limit order for one standard lot of EUR/USD from 1.2209; a buy limit order is also placed at 1.2179.
- A stop loss of 10 pips is used, with stop market orders being located at 1.2219 and 1.2169.
- Erin's profit targets adhere to a 1:1 risk vs reward ratio and are directed toward the range's midpoint at 1.2195. Accordingly, the profit targets function as a buy limit order at 1.2199 and a sell limit order at 1.2189.
Erin's trading plan is designed to capitalise on the short-term range bound behaviour of the EUR/USD. The benefits of such a plan are finite risk, limited capital exposure and simplicity. Should a surprise event spark a sudden trend in the EUR/USD, the stop loss orders protect Erin from financial catastrophe. If the market continues to trade sideways, Erin may execute the strategy repeatedly until the EUR/USD establishes a new range.
A security's trading range is the area between a periodic high and low price point. In the event that a security trades between the periodic high and low for a given length of time, it is classified as range bound. Accordingly, the outer extremes of the range are considered to be viable support & resistance levels.
Trading range bound markets is a technical endeavour, reliant largely upon the interpretation of pricing charts. Upon a valid trading range being identified, various strategies may be applied to capture marketshare in the forex, futures, equities or bond markets. Through the proper alignment of risk and reward, as well as a prudent use of leverage, ranging markets can provide an array of unique opportunities.
Please note that all examples are only shown for the purpose of demonstration and should not in any way be construed as recommending any type of trading strategy and they do not constitute any form of investment advice. Seek advice from a separate financial advisor.