InvestorQ : What is meant by range trading and how can traders use this range trading effectively?
prachi Patwardhan made post

What is meant by range trading and how can traders use this range trading effectively?

2 years ago

As the name suggests, Range Trading is all about identifying and trading range on the assumption that the range will be respected by the stock price. In this strategy a trader identifies overbought and oversold areas and buys at the oversold area and sells at the overbought area. The strategy works well in markets that are meandering up and down with no discernible long-term trend. The strategy is less effective in a trending market wherein a directional strategy of sticking your neck out will work better. When it comes to range trading, there are some basic concepts to be understood here.

Concept of Mean reversion

If you decipher that the price behaviour is either moving toward or away from its average price over time, then the mean reversion strategy will be to determine a market's average price and bet on its reversion. A 5-day moving average shows the market's average price for the past 5 days, a 20-day moving average shows the average for the past 20 days, and so on. When you connect each day's moving average, you create a moving average line. When price moves substantially above or below its moving average, there's a good chance the price will return at least in part toward its average price. The idea of range trading is to capitalize on this tendency of prices to revert to the mean, which is empirically proven.

Supports and resistances

Identifying and measuring the strength of support and resistance is essential to interpreting price charts and successful trading. Support is the price level where buying is strong enough to interrupt or reverse a downtrend. Support is represented on a chart by a horizontal or near-horizontal line connecting several bottoms. Resistance is a price level where selling is strong enough to interrupt or reverse an uptrend. Resistance is represented on a chart by a horizontal or near-horizontal line connecting several tops. Generally speaking, the strength of support and resistance zones is determined by the length, height, and trading volume that has taken place at the level. Very simply, the longer the area has held, the greater the depth of the zone on a chart, and the higher the trading volume when the area has been tested previously, the stronger the support/resistance area.

Trading setups

The goal of a range trade is to find a point at which price has stretched too far above or beneath the average price and must snap back like a rubber band and/or to find a point where resistance or support has formed and is likely to hold again. It is important to underscore that markets vacillate between trending or range expansion periods and non-trending, or range contraction periods. Thus, the first task of the trader is to determine whether the market is in a trend or not in the time frame they are interested in trading. If the determination is no trend exists in the trader's time frame, then the odds increase that a range trading type of strategy will succeed.

To succeed over the long term, it's important that traders enter trades where the profit targets are significantly greater than the stop loss points. So in addition to stop losses, traders should have an explicit idea of where to take profits and the profit target point should be at least 2 to 3 times greater than the stop loss point from where the trade was entered. That is called a positive risk-reward ratio and that is the core of range trading. This strategy of range trading can be adapted for a trending market and not so much for a directional market. In an uptrend, a trader should look for a retracement to buy close to support or when the price falls below its moving average.

A key risk in range trading is the tendency of the market to alternate between range expansion and range contraction. Range traders also lose when they are not prepared for a range breakout. Stop losses can help when the market moves in an unexpected direction.