Range Trading: How To Determine a Trading Range?

Range Trading: How To Determine a Trading Range?

Reading time: 7 minutes

Range trading is a popular strategy traders and investors use to buy and sell in the financial markets within a specified price area, usually defined by support and resistance levels. The area formed between high and low prices in a specific trading period is known as a 'range’ or ‘consolidation’. However, it is worth acknowledging that a ranging market can (and often does) form following a defined trend; this can lead to chart patterns taking shape, such as flags and triangles.

Range traders take advantage of price fluctuations within a range (see Figure 1 below) by buying at support levels (the lows of the range) and selling at resistance levels (the highs of the range). Traders also watch closely for the range to end and either a fresh trend to begin or price to resume its preceding trend.

Figure 1 - Chart Created by TradingView

A trading range is formed when a market moves consistently between two price levels. To help validate a trading range, traders look for at least two tests of either side of the consolidation zone. Once traders identify the range, depending on the trading strategy, they may look to wait for a breakout of the range (these are typically trend-following strategies) or attempt to fade the range limits: buying at support and selling resistance. 

One point to remember when looking at consolidating markets is that the support and resistance levels should generally be marked as ‘areas’ rather than defined levels. For example, Figure 2 shows a range with areas applied to the edges.

Figure 2 - Chart Created by TradingView

Range Breakouts

Unlike range trading, which involves trading within the support and resistance levels, range breakouts involve trading above or below these levels. 

Typically, a trader identifies the range and enters a long or short position as and when price breaks out of the range. Breakout traders approach breakouts differently and apply different filters. While one trader may prefer to wait for price to close beyond a trading range (a close is considered one type of breakout filter), others could enter in anticipation of the break based on how price action unfolds at the range limits. 

Once a breakout occurs, some will enter on the close of the breakout candle (others may be more impatient and enter before the close). At the same time, more conservative traders often wait for a retracement before entering the market, as demonstrated in Figure 3 (arrow).

In Figure 3, you will see that price action (circled) tested the range support area and showed signs of rebounding higher. Despite two attempts to push north, buyers lacked gas at this point and could not find acceptance above $176.50 (ish). This, as well as the preceding downtrend (traders also use the preceding trend as a filter), signalled that range support was vulnerable and a breakout lower could take shape.

Figure 3 - Chart Created by TradingView

Additional Methods of Confirming a Trading Range

As illustrated in Figures 1 and 2, many traders prefer to use support and resistance to define a trading range. As long as the range’s lows and highs are within close proximity of each other, and at least two tests of either side of the range are seen, a range can be determined in any market and on any timeframe. 

However, traders can use additional tools to help confirm a trading range’s limits in a number of ways.

• Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a technical indicator that tracks overbought and oversold levels by calculating the velocity of price movements. 

The RSI indicates overbought conditions once the indicator registers greater than 70.00 and oversold conditions below 30.00. Alongside these thresholds, traders monitor for positive and negative divergence signals that converge with a chart’s consolidation. 

Figure 4 below shows the same H1 chart for Apple (Figure 3) with the RSI applied; notice how a test of the upper boundary of the range was accompanied by negative divergence (red lines). In addition, traders may acknowledge the oversold signal registered when price tested the lower boundary of the range (black squares). However, do bear in mind that momentum oscillators, like the RSI, can deliver false signals and remain overbought and oversold for extended periods. 

Figure 4 - Chart Created by TradingView

• Bollinger Bands

Bollinger Bands is a volatility indicator composed of three lines – an upper and lower band, along with a central band, usually a 20-period simple moving average (SMA). The outer bands are plotted at a standard deviation level above and below the SMA and adjust to price volatility swings; the default is two standard deviations. Since Bollinger Bands indicate whether prices are low or high relative to a mean value, they come in handy when identifying potentially overstretched markets.

Keeping with the H1 chart for Apple (Figure 3), Figure 5 below shows that the lower boundary of the range was challenged alongside tests of the lower Bollinger Band, adding weight to a possible mean reversion trade.

• Moving Averages

Several moving averages exist, though the two most commonly used are Exponential Moving Averages (EMA) and Simple Moving Averages (SMA). The SMA averages the price of an older time period, weighting each closing price equally, while the EMA places more weight on current price changes. Moving Averages are mainly used to identify trends, but they are also used to spot dynamic support and resistance levels.

Using the same H1 chart for Apple (Figure 3), Figure 6 below shows that the test of the upper side of the range was accompanied by the 200-hour SMA, providing additional resistance in this area. Common inputs for moving averages consist of 20 periods, 50 periods, 100 periods and 200 periods (these can be altered according to your trading strategies). 

Figure 6 - Chart Created by TradingView

FAQs

1. What is range trading?

A trading range occurs when a security trades between support and resistance levels for a period of time, during which traders and investors sell and buy assets within this price range.

2. How do you determine a price range?

Traders use horizontal support and resistance lines in price charts to determine consolidating markets; traders tend to require at least two tests of each side of the range to validate its structure.

3. Do traders use other tools to help validate a trading range?

Traders will employ the use of technical indicators and other technical analysis tools to help confirm a range’s limit, such as the RSI, moving averages, as well as drawing tools.