Ask traders how they find the next breakout move, the next runner that’s going to skyrocket to +2000% profit. They’ll likely spout a bunch of technical indicators, screeners, Bollinger Bands, RSI, Stochastic Indicators… the list could go on. Before we even get to these tools, we first need to understand what the stock is breaking out from. So without further ado, here is your lesson on Trading Range.
What is a Trading Range?
When you start to look at charts, one thing you’ll likely notice is the predictable stair-step pattern. This tells you if a stock is moving in an upward or downward trend. But trends are only one part of the trading equation. For the majority of the time, securities move within a price range. This is characterised by a stock bouncing back and forth between two prices. We refer to this as the ‘Trading Range.’
The trading range has two defined price levels. The top or ceiling of the trading range provides price ‘resistance’. The bottom or floor offers price ‘support’. If a stock is moving within a trading range, there is relative market consensus about the stock’s value. When the stock breaks from one of these levels, this indicates momentum and a possible new trend forming. Or it could just be a fake-out — more on this later.
Identifying and measuring the strength of support and resistance zones is essential to successful trading. The strength of the trading range is determined by the length, depth and trading volume. The greater the depth, the higher the trading volume, and the longer the trading range — the stronger the range is considered.
For traders, these levels of support and resistance aren’t just lines in a chart. They are valuable markers, fundamental in identifying entry, exit, stop loss, profit taking levels, and risk to reward ratios. The basics of any successful trading plans.
There are a number of range-bound trading strategies traders use to capitalize on stocks moving within a trade range. We take a look at some below.
Support and Resistance
A simple strategy to use in well established trading ranges, is to buy at support and sell at resistance. Buy low, sell high. Not exactly a thrilling trading setup. But it’s one that could pocket you consistent profits if used correctly.
As with all trading strategies, risk management is essential. You can set a stop loss just outside the trading zone to minimise risk. However, you should beware of the fakeouts. Trading ranges have a tendency to attract lots of traders, which could increase volatility. Market makers are also known to purposely trigger lots of sell top orders by momentarily driving the price down. Only to then buy and drive the price back upward. To avoid being stopped out, you can use wider stop losses — but only if it meets your risk profile.
Breakouts and Breakdowns
Trading ranges don’t last forever. There will be a time when price breaks the levels of support and resistance and a new trend begins.
A breakout is when the price breaks above resistance, while a breakdown is where the price falls below support. Where a breakout or breakdown is fueled by large volume, this tells us that there is widespread activity by other traders and reinforces the reliability of the break.
To avoid ‘chasing’ the price, traders who didn’t open positions before the breakout often wait for retracement before entering a trade. Retracement should be a higher low (vice versa if shorting) and not a return to the trading range. By waiting for the first retracement, traders are better able to trust the validity of the breakout as it shows a genuine shift in supply and demand. Short-term traders will have exited their positions and taken their profits, causing the retracement, and new traders step in to take advantage of the new trend.
Again risk management is crucial and stop losses should be utilised as part of your exit strategy to protect against failed breakouts.
How to Find the Next Runner? Follow the Big Money
As the market cycles between trend and trading range, it’s crucial to learn how to spot potential break, before it happens. The key is to look at volume.
By tracking volume we get clues as to the future price direction. We can track volume by looking at option order flows and tape data. Unlike stocks where order flows are complicated by secrecy and time lag, with option order flows, all trades are printed shortly after execution. The order flow tells us where the trades are being made, the size, type and name. There are no secrets, it’s all on the tape.
When you notice option contracts starting to trade in high amounts of volume compared to their previous average, you can deduce that something ‘unusual’ is going on. When we say ‘high amounts of volume’ we generally mean five times the average daily volume, but the higher the better.
We take particular interest in unusual activity like this, as it can indicate that somebody out there, might know something not yet public and is betting there will be a big move in the underlying asset.
As option contracts have expiration dates, high volumes in weekly options could mean that someone is expecting a big move or break to happen imminently.
We pay even closer attention when there have been large individual orders (the size of the usual day average) or multiple smaller orders executed just milliseconds apart. This suggests that an institution or ‘big money’ is making the bet and something big might just be happening on the horizon. And in the case of smaller block orders, you can guess that the ‘big money’ is trying to stay under the radar.
Be Wary of Hedges
Option flows need to be interpreted carefully. Where a large increase in volume comes ahead of a catalyst like an earnings report or an announcement, it’s safe to assume that the unusual activity is likely just a large hedge taking place, rather than an impulsive directional move.
Hedges are defensive plays. To protect their long term positions, big institutions will buy options to reduce short-term exposure to volatility from catalysts like a disappointing earnings report.
But where there is no catalyst in sight, we may infer that someone is anticipating large moves in the underlying stock. By following the big money, we can get clues as to what the institutions are thinking and how they are positioning themselves. From this we can deduce when a break is near and decide whether or not to capitalise on it — that’s an edge.
Technical analysis is not an exact science. But by pairing technical analysis with options flow data, traders are able to see the ‘bigger picture’ of what is actually happening in the background and plan their moves accordingly.
The key to becoming a better trader is learning to identify and pre-empt the impulsive moves and recognising when they present real trading opportunities. Don’t rush headfirst into a trade. Have a plan. Map out key areas of support and resistance, monitor how the stock behaves as the price moves, look at option flows for clues to future trends and then plan your trade from there.