Range trading is a strategy whereby a trader identifies overbought and oversold areas (or support and resistance areas) and buys at the oversold area (support) and sells at the overbought area (resistance). The strategy works well in markets that are meandering up and down with no discernable long-term trend. The strategy is less effective in a trending market, but can be used if one accounts for the market's directional bias.
Reversion to the mean
If you think of price behavior as a distribution, a price is either moving toward or away from its average price over time. The most popular way to determine a market's average price is through its moving average calculation. 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 values, you create a moving average line.
When price moves substantially above or below its moving average, there's a good chance (all things being equal) 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.
Support and resistance
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.
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.
In a pure range-bound market, a trader can place a buy order close to the market's established support level or at an oversold point when the price has moved well under the market's moving average. A protective sell stop can be placed just below the support area or at a point well below the entry price of the trade. A profit sell order can be placed around the market's established resistance level or at a point close to the market’s moving average.
Every trade will not be a winner. 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.
This strategy can be adapted for a trending 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, as discussed above. However, given that the market is in an established trend, the trader is justified in establishing a higher profit target than they would in a range bound market. For example, rather than selling when the price returns to the moving average, the trader might wait for the price to rise above the moving average before taking a profit.
The risk in range trading strategies stems from the market’s tendency to alternate between range expansion and range contraction. Eventually, price will break out of its boundaries, either on the upside or downside, and a trader banking on the trading range continuing will lose money. That’s why it's important to stop loss orders or some other risk management mechanism to limit losses when the market moves in an unexpected direction.