BY JAMES STANLEY, SENIOR STRATEGIST

THE FUNDAMENTALS OF RANGE TRADING

DailyFX Research Team

Contents
Mean Reversion and the Market State Between Trends ..................................................... 3

Pros & Cons of Trading Ranges ......................................................................................................... 4

Keys Steps to Trading Ranges ........................................................................................................... 4
Is the Trade’s Risk Worthwhile? ......................................................................................................... 5
Disclaimer ...................................................................................................................... 10

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Mean Reversion and the Market State Between

Trends
Range-bound markets are probably the least exciting condition to learn for many new speculators.
Professional traders, on the other hand, usually have a far different view. They know that several
benefits can be had by focusing on ‘less eventful’ market environments.

Previous trading guides have covered market environments defined by ‘breakouts’ and ‘trends.’

Breakouts happen in the transitory state from a range into a fresh trend and are usually driven by news
or some other headline event. These matters are often utterly unpredictable, so focusing solely on
breakouts can be difficult, and oftentimes boring while sitting around and waiting for the break.
Trends are often well known and widely followed. The trouble with trend trading is much of the
developed world looking to do the same thing in ‘buying low and selling high.’

Ranges, on the other hand, are what will often show up when known drivers are properly priced-in to
the backdrop. This allows for sideways price movements where no new highs or new lows are coming
into play. You’ll often hear the term “mean reversion” associated with range trading. Another way of
saying mean reversion is “return to average price.” It represents a market’s tendency to default to the
average price following a large move.

Market Conditions: Daily Price Chart with ADX, RSI, Price Channels Applied

Source: TradingView, prepared by James Stanley

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Pros & Cons of Trading Ranges

Ranges often entail a theoretical cap on the move’s potential because, if the range is to hold, then
prices should turn lower at resistance while catching a bid at or around support. The limited upside
potential is probably the chief reason why so many new traders neglect this very common and
workable market condition. It doesn’t produce the same type of fantasies that can be had from the
infinite projection of a breakout or a trend.

The benefit, however, is defined risk management. If the range breaks, and you’re on the wrong side
of the move, you can exit fairly quickly with confidence that what you were looking for has changed.
There’s little second guessing required because the market condition you were plotting, a range
continuing, proved incorrect. There’s no reason to sit around wondering ‘what if,’ hoping that prices
move back into the range because the idea has already been invalidated. This means that losses can
be mitigated early.

Keys Steps to Trading Ranges

Since the big benefit to trading ranges is defined risk management, the first step is identification of
support and stop placement at the proper location. If the range breaks on the opposing side of the
stop, the trader’s priority is loss mitigation. If the range is going to continue, then support and
resistance should hold. Traders can place their stops underneath range support for long positions
and above range resistance for short-side setups. If either of those are taken out, the position is
stopped out as the trader looks to avoid being on the wrong side of a fresh breakout.

Traders should be aware of risks to stop loss orders. They are vulnerable to short-term fluctuations
in price that could activate the stop price. All stop orders will be filled, though there is no guarantee
of the price. What’s more, if your level is reached, your stop order cannot be filled at a better price
than your stop, only the same price or worse, and this could impact your original risk-reward ratio.

Stop placement is critical. Price channels, often called Donchian Channels, can be incorporated to
assist with stop placement. The indicator can be set up relatively easily using basic technical analysis.
Traders should first identify and connect a series of highs and lows on your chart. Below we can see
an example of this process on a USDCAD chart. The price channel will mark the highest high and the
lowest low over the last X number of periods, with ‘X’ being the input that the trader selects when
applying the indicator. As new highs or lows are formed, the indicator will accordingly move the line

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higher or lower so that, at all points, price channels are showing the highest high and the lowest low
for the past X number of periods.

Daily Price Chart with ADX, RSI, Price Channels Applied

Source: TradingView, prepared by James Stanley

Is the Trade’s Risk Worthwhile?

Once the risk is defined, the trader can then begin evaluating the worthiness of trading it, and whether
the risk outlay is warranted. Traders want to see at least as much upside potential as risk to make it
a workable scenario, otherwise trading that scenario is not attractive.

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Range Risk-Reward Outlay Image

Identifying Range Patterns

From a textbook explanation – ranges are populated by horizontal support and resistance that are
incredibly consistent and continue to hold. In practice, it is rare that a setup presents itself so cleanly.
More often, support and resistance are both messy. In most cases, they are best explained by a ‘zone’
of prices above and below price action that is showing a general sense of turning prices around in
either direction.

Using Price Action to Spot Zones

For traders that are comfortable reading a chart, price action can be helpful in identifying such areas,
looking for price ‘zones’ that have shown a general sense of holding highs or lows in a given scenario.
As with most technical analysis, the longer-term the observation, the better. More opinions and
market motives have gone into that scenario. Newer traders may not feel as comfortable with
identifying such market states, so there’s an alternative to consider.

Help from the Average Directional Index

Rather than looking for the perfect range, the trader can instead look for a simple lack of trend, and
there’s an indicator that can help. The Average Directional Index is a J. Welles Wilder indicator that is

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designed to signify the strength of a trend. Traders can assign a value to the indicator at a level. Let’s
say 25 on the daily chart to denote a lack of trend, at which point mean reversion strategies can
become more attractive. If the level is wildly above or below 25, you’re still in an extreme price move
and likely a trend (or breakout). Remember that prices routinely oscillate around the mean or average
price but typically revert to that same average price over and over.

It’s important to note since we’re incorporating an indicator here – lag will happen. The Average
Directional Index, or ADX, like most other oscillators, is based solely off past price information. So, it
will often be slow to register a new breakout as it’s getting priced-in, which means that it is important
for traders to stick to their risk management plan regardless of what ADX is doing. The inclusion of
the indicator is as a simple filter – looking for markets that have been devoid of a strong trend so that
mean reversion strategies can be attractive.

Daily Chart with ADX Applied

The RSI Indicator

After a trader has filtered out strong trends and identified a market that’s in a state of digestion or
congestion from its prior major move, entries can then be plotted. For such a scenario of mean
reversion, there’s another indicator that can come in handy. The RSI indicator can be used to plot
prices on the daily chart. Rather than using the 30/70 levels, traders can look to 40 and 60 for triggers.

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A cross up-and-over the 40 level can open the door for bullish setups while a trigger down and below
the 60-level opens the door for short-side setups.

Daily Chart with ADX and RSI Applied

Source: TradingView, prepared by James Stanley

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Range Trading Strategy Checklist

1. Understand the pros and cons of trading ranges

Although range trading can have limited upside potential, they also provide an opportunity for traders
to quickly exit a failed setup, hence limiting exposure

2. Learn the key steps to range trading

Since an important range trading benefit is defined risk management, placement of stops is crucial.
Many traders use price channels, which can be set up by plotting a series of highs and lows

3. Remember ranges are usually messy

Rare is the range populated by clean, consistent horizontal support that holds. Traders use tools to
find zones.

4. Take advantage of tools to identify range patterns

Traders often turn to price action to identify zones; they also use the Average Directional Index, or
ADX, and the RSI Indicator.

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