One of the most commonly unknown features of financial markets is that instruments do not trend higher or lower all the time. In fact, some instruments spend the majority of their time trending sideways, moving horizontally over time. For stocks in particular, it is estimated that they have a tendency to move sideways a majority of the time.
When evaluating potential trading opportunities, horizontal ranges can provide tremendous value. Irrespective of your trading time horizon, whether short or long-term, range-based trading offers a unique advantage from the perspective of reward and risk.
Visualizing a Horizontal Range
The most basic form of technical analysis besides understanding trends is identifying support and resistance levels. Besides giving us valuable information about where buying and selling pressure in an asset lies, they can help us determine effective entry points and targets for potential trades. Horizontal trading ranges in particular are formed by the combination of a support level and resistance level that have been periodically tested and remained unbroken.
Generally, the rule for identifying a horizontal range is finding at least 2 to 3 points of contact of either horizontal level without them being broken. A broken level suggests the range is no longer active, but is generally dependent on a candlestick close above resistance or below support. As mentioned above, ranges can be found across asset classes in a variety of different time periods.
Trading a Horizontal Range
Unlike trends which involve trading with the trend or against the trend, horizontal ranges provide the unique advantage of enabling investors to establish both Call and Put options. When an asset is trading near the upper end of the range at resistance, ideally, a Put position is established targeting the lower bound of the range. At the bottom of the range, the ideal strategy is to establish a Call position targeting the upper bound of the range.
While it appears simple at first glance, it is important to seek confirmation from other indicators to determine if the entry point is effective. In particular, it is helpful to use oscillators such as the Relative Strength Index (RSI), Stochastic Oscillator, and Commodity Channel Index (CCI). These oscillators have a tendency to indicate whether an asset is overbought or oversold.
Generally, if an asset is at the top of an established range, you want to see an oscillator that appears overbought. This suggests that an asset is slightly overvalued, raising the possibility of a retreat and representing a potential place to establish a Put position. The same goes for an asset trending near the support of a range with an oscillator that appears oversold. The oversold oscillator suggests than asset is undervalued and ripe for a bounce, indicating a great potential entry point for a Call position.
The beauty of range-based trading is that while the range remains intact, there are opportunities to take advantage of rising or falling price action and playing each side of the market. If patient and disciplined, a range-based investing strategy can really pay off longer-term.
What if the Range is Broken?
Horizontal ranges typically do not last forever and are prone to breaks of the support and resistance levels. However, there are two types of breaks. When viewing a range on a candlestick chart, a candlestick close above resistance or below support for the period being measured indicates that a breakout has occurred, suggesting the range is broken.
Periodically, a candlestick will break the levels, but not close above resistance or below support. This is commonly referred to as a fake-out or shake-out move intended to trick investors. However, if unbroken by a candlestick close outside the range, a range remains intact and active.