What Is Range-Bound Trading?

What Is Range-Bound Trading?

Reading time: 7 minutes

Whether trading Forex, commodities, digital currencies or in the stock market, you will invariably encounter periods where price moves sideways. Void of a definable trend, ranging markets can offer unique opportunities and challenges.

(Figure 1)

A range-bound market fluctuates between two horizontal points of support and resistance (usually marked as areas rather than defined levels), as shown in Figure 1 (EUR/USD 30-minute timeframe). A support level represents an area on a price chart where buyers tend to overwhelm sellers, preventing price from falling lower. Resistance, meanwhile, is the level at which sellers often take over, stopping price from rising further. You can think of support as a temporary floor and resistance as a temporary ceiling. 

Support and resistance levels can be identified across any market and timeframe, often prompting reversals or breakouts, depending on the trend's strength. 

The basic idea of range-bound trading strategies is to buy (enter long) at support and sell (enter short) at resistance and ‘rinse and repeat’ until a breakout of that consolidation emerges. It must be noted, however, that many traders do not rely solely on the range edges to enter long or short. Experienced traders and investors complement their analysis with additional technical analysis tools and fundamental analysis. 

Characteristics of a Range-Bound Market

While we have stated that a financial market is range-bound if it trades between two horizontal price levels repeatedly, determining whether an asset’s price is range-bound or just taking a temporary breather requires a more nuanced approach. Generally speaking, if a market has reversed from horizontal support or resistance twice (i.e., twice at support, twice at resistance), it’s likely a rangebound market. 

The Relative Strength Index (RSI), a popular momentum gauge, can help identify/validate a ranging market, through overbought and oversold markets at the 70.00 and 30.00 thresholds, respectively. Ultimately, if the RSI tests overbought at the same time the underlying price tests range resistance (for, say, the second time), this helps confirm potential resistance and, therefore, helps confirm a consolidation might be present, as shown in Figure 2. 

Lastly, the Average Directional Index (ADX) can also be a valuable tool. Generally used to detect trending markets, a low ADX value (25, or especially below 20) indicates little to no trend is present. Under these conditions, it’s more likely that an asset is range-bound.

(Figure 2)

Pros and Cons of Trading Range-Bound Markets

So far, learning to trade range-bound markets sounds simple. 

Just buy at support and sell at resistance, right? 

While range trading has its merits, there are also disadvantages to be aware of.

Pros:

• Defined Entries and Exits: Using consistent support and resistance areas provide clear areas for entries and exits, reducing subjectivity (for example, enter short at the lower edge of range resistance and position protective stop-loss orders just north of the area).
• Predictability: In a range-bound market, prices move with relative stability and low volatility. This generally makes technical analysis more straightforward.
• Suitable for Beginners: Range trading is an accessible approach, given the simplicity of the idea, making it a good starting point for new traders. 

Cons:

• False Breakouts: There are occasions where price will momentarily break the established price channels, potentially triggering a trader’s stop-loss order and leading to confusion. This can also be referred to as a whipsaw or a stop run. 
• Limited Profits: Range trading restricts the chance to capitalise on big price movements. For example, a trader might exit at resistance only for the asset to surge higher. This is commonly seen after a defined breakout materialises and a trend emerges. 
• Higher Trading Costs: Frequent buying and selling, particularly if day trading, can lead to increased transaction costs.

Trade and Risk Management in Range-Bound Trading

Effective trade and risk management is key for success in range-bound trading (this is also true for any trading or investing). Regarding exit points (profit taking), many traders close the position at the opposing level. For example, if opening a buy order at support, they would exit at resistance and anticipate a bearish reversal for another potential sell trade.

In risk management, the most common technique is to set protective stop-loss orders just beyond the high or low of the trading range. In the event of a breakout, this acts as a safety net to limit potential losses. Some traders and investors also look beyond the range edge to neighbouring support and resistance levels to avoid a potential whipsaw. However, setting a wider stop loss can mitigate the chances of being stopped out by a false breakout, but at the same time, this will worsen the risk/reward ratio of the trade. 

The Bottom Line

In summary, range-bound trading can be a rewarding yet challenging approach. While the idea is simple, several nuances make it more complex than appearances suggest. However, with a basic understanding of how to identify ranging markets, you can start exploring other ways of confirming range limits, such as higher timeframe support and resistance, technical indicators or even a fundamental approach to help back the idea of a consolidating market.