Welcome to our Introduction to Trading Range! 🙂
If you have been following our Trend Trading Guide, you’ll probably feel that price actions in trends is often not difficult to read. This is because there are a number of pattern that gives insight into the strength of a trend.
On the other hand, trading ranges is so much more random in behavior, particularly its’ price action within the range.
Hence, the best we as traders can do is to test the validity of support and resistance near the confines of the range. But take note that it is very complex!
There are some signs and pattern which we observe which tests these support and resistance levels. Typically, the associated patterns are signs that breakouts is going to happen. But breakout doesn’t always mean the trend towards the direction will carry on as well. Breakout tend to fail half the time and go to the other direction completely. Nevertheless, these patterns will be important as a warning sign as well as information to what is happening in the market.
Before we go in-depth into the structures we can see in ranges, we’ll cover some basic of Support & Resistant levels.
It is Potential Support Resistance Level!
Firstly, this may seem redundant and insignificant, but it is an important mindset to have while trading. Traders should not expect that price is going to react to a Support & Resistance level on an exact price. Nor to the market price obligation to bounce in between the two levels like a sin wave!
Obviously it is easy to identify a support resistance level when we look back at the chart. It is a different story if we’re looking at real time on the right of the chart.
Just know that if prices stop at some point in front of a level, or for the level to be violated, it means that many traders are watching that price level.
Also, there is a saying in almost all trading education that says broken support becomes a resistance and vice versa. Why? It is particularly true especially in an obvious level where traders are keeping an eye on that price level. Hence, buyer seller rallies up with respect to that level. We’ll check out some interactions that could happen in Support Resistance level!
Support Resistance in Action
In most cases, a significant support resistance levels are the ones that likely to have an actual impact on prices. And these levels are often obvious on price chart and would work in a nonrandom manner. Usually because many market participants are watching that particular level and it is obvious to everyone.
Such as visible pivots (especially on higher time frame), levels that are tested several times, extremes of large spikes and highs and lows of previous day. These areas may attract a lot of attention and interest by market participants.
Classic Accumulation or Distribution
Sometimes there are important information within trading ranges with the presence of price structures suggesting large interest of accumulation or distribution in stocks.
A spring is a quick drop below support level and immediately finds enough demand to push the price back up above support. An upthrust is a push above resistance level and it immediately fails as market meet sufficient supply to push the market back down. Both are actually fake-outs which does nothing useful for a trader except stopping traders out of their position. This happens when they run stops outside of a support resistance level.
Hence, these two serves as an important pattern to identify accumulation or distribution phase in a Wyckoff market cycle model.
Trading Range as Functional Structures?
Alright, by now you would probably think, if trading range is a random structure that proves to be quite unreliable to even trade in. Maybe we should wait for a strong imbalance causing a trend in price and buy at pullback.
That is a pretty good mentality to have as it causes you to wait for an edge to your favor. However, there is a saying when the price chart shows a trend, sometimes it is too late to reap good profit out of that movement. You may find that when the price chart is obviously showing a trend towards a direction, we may be forced to chase the price and buy/sell aggressively. Ultimately entering a trade at a less optimal price.
So what can we do about it? Well, trading ranges although random, there are some patterns which are useful to us.
Market tends to alternate between trending period and trading ranges. Trend prices continues moving in the same direction due to imbalance of buying selling pressure. Price movement are more or less predictable in terms of direction, magnitude and timing. On the other hand trading ranges are directionless and somewhat random in nature where market are in equilibrium. So in terms of direction, magnitude and timing it is less predictable.
However, trading ranges generally have two structural functions in relative to the previous trend. Either a large scale continuation patterns or they may also function as a reversal pattern. Traders who are aware of these different functions and some distinguishable factors can shift the odds into their favor!
Very often it is by positioning for the next major trend movement within the trading range. HOW?
Traditional technical analysis tells us that trading range are usually consolidations in the trend that comes before them. Statistically, this makes sense to a certain degree that there will be continuation of trend, until there are patterns that shows trend termination of course!
It is also helpful to visit the higher time frame as the chart enters a large trading ranges, which are random and unpredictable.
Higher time frame usually will tell us whether the trading time frame have pushed the higher time frame into an overbought or overextended condition. And the unreadable range on the trading time frame (shorter time frame) is actually just a simple pullback on a higher time frame. This case, the higher time frame provides us with clarify on prices movement and deny noises from the lower time frame.
For example, the figure below shows a daily and weekly chart for S&P 500 Cash index of 2008. The daily chart (left) is pretty much a mess going into a range suddenly from a downtrend. Plus, there are many conflicting signs we see in that chart itself. However, the chart on the right (weekly chart), shows a clear pullback in a downtrend and a continuation pattern.
On the other hand, another possible situation we can have out trading ranges is a reversal of a higher time frame trend.
For example, the chart below shows another S&P 500 chart with highs in early 2010. The weekly chart is overextended and daily price suggest a certain lack of conviction at the highs. In this situation, many would be looking at a counter trend trade if it closes below a certain price level. Which was the previous YTD high and turns out to be the exact high of the market for many months. Ultimately, the short was successful a few days later as well.
But do note that this is not simply a directional call or decision. Many times we know that these calls are the best case scenario when we see some signs of potential reversals. Sometimes, the signs aren’t obvious and traders have no justification for taking any position. Hence, it is best to stay out of the market while usually the market would stay flat as well until further clarification.
Volatility Conditions on Trading Range
It is a futile effort catalog every single variations of patterns that happens within a trading ranges. Simply because it is almost random in nature in terms of price action. Visually, the most important factor in differentiating the different types of ranges is what is happening at the edge of the range.
For instance, are they contained in a parallel line, is the edge converging or are they expanding? Each has subtle differences with some effect on the expected outcome of the pattern.
Parallel Range: The Box
The simplest range is the one that trades between parallel prices in a box formation. The volatility are fairly constant for the duration of the range.
On lower time frame, we will see trends that terminates in the trading time frame support and resistance. The confined range may be violated but violations doesn’t necessarily mean a breakout. As most violations are short lived and simply expands the range.
Another variation of this box pattern is a diagonal trading range, which is a box sloping towards a side. This is very common as a retracement in higher time trend. In fact, the diagonal range sloping against the higher time frame trend is considered to be the most common pullback pattern. Again, there may be violation of this parallel range in lower time frame and do not expect perfect and clean tests.
It is an important pattern because it is often defined as a complex pullback. Be wary of springs near the support of the larger scale uptrend and upthrust near the highs of the downtrend. These often gives exceptional entries on a higher time frame trends!
The final structure to be aware of is a tight consolidation near the edge of one side of the range, as shown in the figure below. In a common support resistance level, we expect to see a price rejection near these levels and price would bounce back on the other side.
But if the prices are able to consolidate near one side of the range, this shows pressure building up against one side of the range. This is a classic sign for a breakout.
Another common variation we see in charts is that the trading range sees the market making successive smaller swings. As if it is zeroing towards a particular price. The edge of this range seems to converge at some point in the future and this pattern often appears to be a triangle on the chart. Traditionally, these patterns often set up good breakout trades and there are rules regarding the direction and price targets for these breakout.
But based on price movements nowadays, these traditional rules may not be reliable and effective. Sometimes they work, sometimes they don’t. Hence, it would be safer to not take the trade on the first breakout from one of these formations. You will not want to end up in the wrong side of a strong move following the first breakout which may be a fake-out.
There are many variation of triangles or converging ranges in the charts. Such as symmetrical triangle, ascending or descending triangle wedges, pennants and so on. Essentially they are basically the same pattern. It shows volatility compression that puts us in a breakout mode looking for continuation out of any of these breakout. But many of these patterns are as random and can be unpredictable. Hence it is better to avoid incurring losses when we see such formation since it is difficult to trade.
On the other hand, an ascending triangle may be more significant. As the price holds successively smaller declines (higher lows) into a resistance level or the same formation inverted to the downside. It reflects weaker price rejection from resistance and usually leading to a breakout above that resistance.
Lastly, there are some formation relating to widening triangle as opposed to the converging triangles above. Some can be a diamond shape formations where price first expands and then contracts into a classic triangle and of course there are rules with regards to trading these patterns.
However, seeing the expanding triangle patterns prompts some sort of confusion within the market and preferably, I do not want to have a position in this market type. It is tough to define your risk and reward when the volatility is expanding in an unpredictable direction. Typically we do not see strong move out of this pattern as well.
More often than not, they end up into a random, directionless, low volatility ranges. It is better to avoid this situation to significantly reduce your risk in exposing yourself to its’ randomness and expanding risk.
Compared to Trend Trading, trading ranges are more complicated and random. It provides more challenges and dangers to traders who would trade within these ranges.
It tends to create illusions of patterns that doesn’t exist in these ranges which produces multiple losses if someone tries.
However, market structures usually alternates between trend and trading range patterns. But at the same time it is not possible to have an understanding of supply and demand without understanding of trading range. And also price action around the support and resistance. Hence, this article that describes certain logic in some patterns amidst of the trading range randomness.
Many of the best opportunities comes at the point where trends becoming trading ranges and vice versa. But many losses comes from the very same area as well.
SO, that is what we’re going to be covering in the Interfaces between Trend and Trading Ranges next!
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