Trading Range Explained chart indicator example strategy Profit from Market Ranges

Trading Range

The extension of the double and triple formations to the concept of a range is natural in a sideways market. Without a clear trend, prices will meander and oscillate in a narrow range. This can be confounding for long-term investors who are not sure what direction the market will take. They may find this period frustrating.

The range offers traders the ability to trade long and short with reasonable precision. A cap is placed on gains by resistance while support keeps losses in check, thus creating a range-bound or trading market where buyers and sellers can find ample opportunity to capitalise on.

The illustration beneath demonstrates the stock’s typical pattern of movement.

As you can observe, the stock moved between an identifiable range of Rs. 128 to Rs. 165 multiple times. This area between these two figures is referred to as the width of the range. An easy trading strategy would be to purchase near the lower level and sell near the higher level, or alternatively, open a short at a higher point and then repurchase it near the lower point.

This chart provides a great illustration of the combination of Dow Theory and candlestick patterns. Take note of the circled candles from the left-hand side of the chart:

1. The bullish engulfing pattern is indicating that the trend is likely to continue.

2. Morning doji star suggests along

3. The bearish engulfing pattern indicates that a short may be likely.

4. The bearish harami indicates that a short is likely.

A short term trader would certainly want to take advantage of trades like these – they’re easy to spot, and bring a high likelihood of good returns. The period these ranges cover could be anywhere from a couple weeks to a couple years; the longer the duration, the wider the range.

The range breakout

It is interesting to understand why stocks trade in a range, and after extended periods of time, they often break out. Let’s explore this further.

Stocks may fluctuate between high and low prices for two main reasons.

1. When nothing is driving the stock, there may be a trading range, until a significant stimulus – such as a quarterly/ annual result announcement, new product launch, geographic expansion, change in management, joint venture or merger/ acquisition – occurs. Under these circumstances the range can remain in play for an extended period of time.

2. Anticipating a major corporate declaration, the stock could leap either way depending on the outcome. Until it is officially announced, both buyers and sellers will be reticent to act, leading the stock to enter a range. This range can be temporary, often ending once the event has come to fruition.

Once a stock is in the range, a breakout may be imminent. This usually indicates the beginning of a fresh trend. The direction of the breakout will likely be influenced by the trigger or event outcome. Regardless, its significance lies in the trading opportunity presented.

A trader will take a long position when the stock price exceeds resistance levels and go short when support fails.

The range can be compared to a compression chamber, where the pressure gradually grows each day. A small outlet allows the pressure to be released with considerable force – this is how breakouts occur. But traders need to take heed of the possibility of false breakouts.

A false breakout is when the catalyst behind the price movement isn’t enough to sustain a trend, often resulting from an opportunistic response to a trigger which isn’t particularly favourable. Generally, trading activity is low in such situations, and it’s likely that there aren’t any shrewd investors behind the move. As you’d expect, following such a manoeuvre, the stock will typically return to its former range.

A true breakout has two distinct characteristics:

1. Volumes are high and

2. Following the breakout, the rate of change of price has increased significantly.

Have a look at the chart below:

The stock attempted to break out of the range three times. However, two were unsuccessful. The first occurrence had low volumes and momentum while the second showed impressive volumes but was still unable to break away.

This 3rd breakout had all the characteristics of a classic breakout, with high levels of volume and strong momentum.