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.
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.
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.
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.
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.
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.
Source - cache | Page ID - 36082 - en