Last week’s skid is likely to produce buying opportunities soon, but those opportunities are also likely to be limited by range-bound behavior in the major indexes for at least a little while longer. Consider the following chart of the Nasdaq 100.
Figure 1 - 3 month chart of QQQQ.
In Figure 1 you can see the recent rise from June lows and subsequent recreational cliff jump after the Fed announcement have shaped up a market that is rising to, but not through, its previous highs. This sideways range may last through the rest of the quarter as summer winds down and investors tiptoe into 4th quarter positions.
The sideways trend we now see, making neither higher highs with higher lows nor lower highs with lower lows in sequence, may last for a while longer--perhaps until next earnings season in early October. A sideways trend as two important implications; First, you can profit while in these trends by trading from the extreme to the mean prices, and second, you can also profit from a trade once the trend breaks out to either a new bullish or bearish trend.
This article will describe how to trade from any sideways trend while it lasts, by using four steps. First, define the range. Second, mark an expected variance. Third, make trades in anticipation of moves back towards the center of the range. Fourth, be prepared for the breakout signaling the end of range-bound trading.
Step 1. Define the range.
To define the range you have a choice: trust your eyes or trust the numbers. You can simply draw lines across the highest and lowest prices you see, or you can use a tool such as a Linear Regression study if it is available in your charting tools. In my experience, there is not an empirically demonstrable advantage of choosing one method over another. Pick some lines and go with them and don’t get wrapped up in trying to make them perfect. After all, step two assumes you never will get it perfectly right anyway.
If you don’t feel comfortable drawing lines, you can let the computer do it for you, but putting in any one of the following: Bollinger Bands, Keltner Channels, Moving Average Envelopes, or Linear Regression Channel studies. These can be found in a number of charting packages offered by your brokerage or other chart provider.
Step 2. Establish an acceptable variance
Sometimes stocks follow a range within a penny or two. But the majority of the time, it does not happen that way. If you drew channel lines based strictly on the high and the low of the chart you see today, and then try to use these lines as precise entry points for your trades, you will likely be disappointed for a number of reasons. A more realistic approach will be to make your target entry prices just inside the channel by a small amount, and set a stop loss.
A simple tool for determining a useful variance from the channel is the Average True Range (ATR) study. This study, as its name suggests, finds the average difference between the highest and lowest prices in each time period you are studying and it also includes gaps in its calculations. In sideways trading strategies, you can accept that any deviance from your defined channel greater than the ATR amount will imply a strong possibility of a new trend in that direction. With this in mind, you can add the ATR amount to your upper boundary line, and subtract the ATR from your lower boundary line. These newly drawn price levels will form your stop loss levels for either short or long trades.
Step 3. Trade in anticipation of a move back to the center of the channel.
In sideways moves, many traders limit themselves by thinking they can or should trade from one boundary of the channel to another. The sideways trend is not always regular and if you expect it to be, you will often be disappointed. It is easier to trade from the upoer or lower line towards a price level marked as the center between the two lines drawn. Such a price level should be your profit target when you enter a long position at the lower price limit or short position from the upper price limit you are using. Notice how the current market action paused right in the middle of this channel.
Even if the index in does not trade in such a range for long, you will likely get a one or two clear opportunities for such a trade. But it is also possible that prolonged range trading could last a long time. As pointed out in Figure 1, the volume has been declining all through this sideways range. This is typical of a price pattern signifying indecision. As summer winds to a close, the volume could pick up and change the trend.
Once you have implemented these four steps you can execute any number of trading strategies to extract value as the indexes move from one extreme of the range to the other. Strategies such as swing trading or options strategies that profit from the passage of time—like Iron Condors or Calendar spreads—tend to work well through these periods.
Step 4. Prepare for the breakout.
Be on the lookout for a reversal towards a breakout move. Such a reversal will often include an engulfing candle pattern, or an outside day reversal (if you prefer to look at price bars instead of candles). If such a day crosses the extremes of your sideways trend and shows strong volume, over 150% of recent average, then you’ll have your breakout signal.
Should a breakout occur, you could use that as a new entry for going with the trend. More about that in my next article. Until then, click here to see a walk through of what I have written about in this article.