Markets moving strongly in one direction or the other make trading look easy and seems to offer the key to vast wealth. Unfortunately, markets spend most of the time trading within relatively narrow ranges that can frustrate traders. Knowing how to trade range bound markets can lead to profits during these narrowly moving times.
The mistake many traders make is trying to apply the same set of tools to all types of market action. While this is a sure fire recipe for disaster, it is the most common approach to the markets.
It is relatively easy for a beginner to learn about a technical indicator and find an example of a time it worked exceedingly well. Overlooked are the more plentiful times that the indicator led to small losses, which add up over time and have the potential to destroy a trading account.
One of the first steps to successful trading is to determine whether the market is trending or not. Anecdotally, most traders believe that markets trend less than a third of the time. The rest of the days, prices bounce between what are called support and resistance levels.Support can be thought of as a price level that keeps a floor under a stock price. Often during a decline a stock will reach a low level and temporarily move higher. Then the decline resumes and the price bounces off the recent low. This is called a support level.
Resistance refers to a price on the upside that temporarily stops an uptrend. On a stock chart, support and resistance levels can be drawn as horizontal lines. These lines tend to be fairly close together, perhaps 10% apart.
The Average Directional Index (ADX) indicator.
When the value of this indicator is below 25, it indicates that the stock is in a trading range. Using trend following tools while it’s in a trading range will lead to small losses, such as when the price breaks through resistance and then falls back into the trading range. We also see an example where price temporarily broke support and quickly returned to the trading range.
Some technical indicators work best in trading ranges. These are called oscillators because they are also range-bound. Oscillators are calculated to have upper and lower limits. One example is the Relative Strength Index (RSI) this oscillator is:
RSI = 100 – [100/1 +RS]
RS = Average of N-period up closes / Average of N-period down closes
In the RS formula “N” is the number of periods used in the calculation. Many technicians use 14 periods as their default, although shorter and longer periods work just as well. In the calculation of RSI, to find the average of the up closes, add all daily gains for the last 14 days and divide the total by 14. The average of up and down closes is always found by using N as the divisor – a common error is to use the actual number of up or down closes.
RSI can be calculated over any time frame, from minutes or less through years.
RSI is usually displayed as an oscillator on a chart. A common use of this indicator is to determine overbought or oversold levels. Most traders use values of 70 and 30 for this purpose. When the price action drives RSI below 30, it is considered to be oversold and ripe for a buy signal. When the indicator rises above 30 it is usually thought to be bullish for the underlying stock. Overbought stocks see RSI rise above 70, and falling below this value is considered as a bearish signal.
These rules are the basis of our system for trading in a range bound market. The first step is to confirm that the market is in a trading range. This will be done by ensuring that ADX is below 25. Then, look at RSI. If it is above 70, sell when it falls below that level.
The buy signal occurs when RSI falls below 30 and breaks above it. That would be the signal to close the short trade. This trade resulted in a 6% gain in only one week. The key is to wait until the indicators tell you to trade.
Trading is a difficult way to earn a living. It appears to be deceptively easy when looking at a historical chart. But using the wrong tool for the market environment can actually damage a trading account beyond repair. Looking at a trend indicator, such as ADX, tells you whether to use trend following tools or oscillators which work best in trading ranges. The right tool, applied at the right time, can lead to profits.