Year-End Trading-Range Strategies for the Smart Trader!
November 4, 2011
It is a common misconception that when most investors hear that stocks will likely trade in a range, they immediately assume that there is no money to be made.
However, during moments of limited market volatility, or as can be experienced at certain times -- major volatility within the range, an ideal opportunity presents itself to profit from the zigzag motions of the market -- trading-range strategies can come into play very successfully.
A range bound market is characterized by levels of higher buying pressure, known as a support, and higher selling pressure, known as a resistance. These levels create a channel, where market movement is generally concentrated within these key levels. As major support and resistance levels are defined, range traders apply the unique concept of buying at support and selling at resistance. Or, if you tend to concentrate on options trading – either way the market is trading, becomes a trading opportunity!
Defining Range Trading
Range trading is a strategy that involves buying as price moves to lower support levels, and selling as price moves to upper resistance levels.
Range trading is a non-directional strategy which is based on the underlying assumption that 80% of the time, price action does not trend, but rather channels. Range trading offers several advantages including simplicity, and defined risk reward parameters.
By focusing strictly on price movements and congestion points on the chart, range trading allows traders to ignore news-flow and simply concentrate on well defined areas of support and resistance -- and employing some very sound trading-range strategies.
The fact that the market trades around 80% of the time in a range, the range-bound strategies can become significantly lucrative to traders. However, traders need also to identify limitations to the strategies that arise when a pair breaks out into a strong trend. Thus, it is essential to know how to take advantage of these strategies and when are the best conditions to apply them.
Many of the top traders know how to apply this strategy and make money whether the market goes up, down or sideways. The key to success is having clarity as to which direction stocks will head in the future. Due greatly to the historic Greek bailout referendum vote, the odds have greatly increased that stocks will be locked in a range until January.
The Trading-Range at the Present
The European debacle, especially the Greek indecision, seems to have locked the market into a trading-range that will last until the end-of-the-year, if not longer. And then, when this is supposedly under some sort of control, it is likely that further complications will arise – welcome to the uncertainty of the economic world!
An understanding that nothing is 100% certain in the future of the market movements, but it’s vital to assess when the odds are in your favor and then take action.
Thursday's rising optimism of a bailout deal to be made with Greece had markets on both sides of the Atlantic soaring higher.
Now we are within striking distance of the two hundred day moving average at 1274 on the S&P. However, the markets will be hard pressed to get above this moving average until a deal is solidified. If one comes shortly, then expect a lightning strike up to 1300+. Unfortunately, if the deal fritters away, then don't be surprised with a ride back down to the fifty day moving average at around 1189.
The Information and the Range-Bound Situation
By taking into consideration the trading landscape over the past few months it is quite easy to see the situation as it stands today and should give us a fair image of what is to come!
The chart of the S&P 500 (SPX) below clearly shows that we were locked in a trading range between 1120 and 1220. People didn’t want to go lower until there was more proof of a recession -- and didn’t want to go higher until the odds of recession were greatly diminished. We did not break out of the range until Q3 GDP came in at +2.5% and it “seemed” the European situation was under wraps.
Recently we exited this trading range period and emerged into a new one framed by the 50- and 200-day moving averages (see chart below -- range of the S&P 500 is 1189 and 1274).
It will be hard to go below the range unless certain that the Eurozone will implode from the situation – it is also hard to move above until the Greeks accept the bailout package which should bring some level of calm. That would also allow investors to once again focus on the positives in the US stock market (modest growth, big dividends and attractive valuations).
Trading-Range Strategies for a Range-Bound Market before the End of the Year
There are several very sound trading-range strategies available that would be very profitable in this market – cash hoarding is definitely not one of them – this is safe but certainly not profitable. However, observing the trading-range strategies available, and the odds being stacked for success, it is advisable to take full advantage of the situation.
Blue Chip Strategy:
At uncertain times investors generally seek safety. That includes cash, bonds and blue chip stocks. Right now there are many quality companies that are paying out 2 to 5% dividend yields which put Treasury bond yields to shame. The total return on this kind of portfolio has good odds of beating a market that will likely be just breakeven.
For the very Brave:
There are some people who believe that they know already the outcome in Europe...and what that means for the US stocks – which means that they will dive into the deep-end – sink or swim – using long or short calls before the rest of the cards are dealt out. Those who guess right will profit greatly, those that predict incorrectly will suffer badly – this is definitely not for me!
Trading Up and Down in the Range:
Look once again at the first chart. See how many times over the last few months stocks hit the top of the range and headed lower. And then see how many times it hit the bottom of the range and headed higher.
Now look at the chart below of EMC Corp. (EMC) and a similar pattern emerges – this is where the profit is to be found!
You could not draw up a better scenario for active traders to make profits by using trading-range strategies.
Another example of this range-bound market is Apple Inc. (AAPL) – again, plenty of opportunities abound.
Adopting the Trading-Range Strategies
If you think you have a range trading market that you would like to trade, then your first task must be to identify the range of prices that the security is trading within before applying any trading-range strategies. This involves determining a support level, that is a price which the security touches but doesn't go down through, and a resistance level, which is similarly a price above the trading range which the price does not pass up through. You should look for the price to touch the support and resistance at least a couple of times, as this gives you some confidence that the levels are going to remain. The more these levels are touched and the price is rebuffed, the more you can trust them to perform well in the future.
The process of the trading-range strategies, to make a profit from the range-bound market, is then, simply to buy at the support level and sell at the resistance. You can also sell short at the resistance and buy to cover when the price drops to the support. At least, that is the principle that you're trying to apply.
One strategy that can be applied, which can be extremely effective and profitable, is to use options. A simple option play is to buy puts at the top of the trading-range and buy calls at the bottom of the trading-range – consideration must be observed as to the size of the trading range.
One point you should always watch for is that the price may 'break out' from the range, and you need to protect yourself from any losses being too great if this happens. If you watch the volume of trading, and look at the oscillators for signs of an overbought or oversold market, then you may be able to spot the warning signals for a breakout that would keep you out of the trade and perhaps allow you to plan a trade in the opposite direction.
Another strategy to employ is to observe when the price touches the support or resistance line, then place a buy stop order (or sell stop order) just away from the line so that it is triggered as the price starts coming back. This provides some protection against the price continuing its run right through the line, making a breakout.
As always when you place a new trade, you should set a stop loss order to prevent an adverse trade from affecting you too badly. In this case, the level is easy to see. You set your stop loss just outside the support or resistance level so that a failure of it to hold as you expect would immediately take you out of the trade for a small loss.
Hopefully you see this trading-range trend emerging. If so, then be sure to enact one of the trading-range strategies above that makes the most sense to you.