Trading ranges and range breakouts offer some of the most common and potentially most-profitable marketplace scenarios encountered by forex traders. Yet, many traders are unable to build a winning strategy to profit from trading price ranges and breakouts.
The secret to successful range trading lies in identifying trading ranges and breakouts as early as possible, and then trading them proactively before the herd comes in and drives the price too far in either direction.
By using the right tools, ranges and breakouts are fairly easy to spot and take advantage of. Ranges offer something for everyone: Range traders work to trade currencies while prices remain within the range, and breakout traders focus on entering positions when the currency pair’s price leaves the range.
Properly traded ranges can be very profitable – When breakouts occur, they can yield huge returns. Meanwhile, range-bound forex trading strategies offer a slow, steady way to accumulate gains.
Still, it’s critically important to trade carefully: The keys to success are to avoid trading false breakouts and corrections, manage risks appropriately, and keep the expectations realistic.
In this article, I’ll describe some ways to identify and confirm stable trading ranges, which can then be successfully exploited by mechanical trading systems using a wide variety of strategies.
What’s a trading range?
The term “range” refers to the difference between the high and low prices for a given currency pair during a given time-frame. Range is the price spread during the time-frame, and it also represents the volatility of the currency.
The more volatile a currency price is, the wider its range. Obviously, the longer the time-frame, the wider the observed price range. For mechanical trading systems, ranges are useful for determining technical support and resistance levels as well as setting entry and exit orders.
Likewise, range is a measure of risk – The wider the range, especially during short time-frames, the riskier the currency play. By choosing the right trading strategy and employing appropriate risk-management measures, a forex trader can harness the power of the range to achieve excellent gains.
A trading range or channel occurs when a forex price trades at or near the same price over a period of time. When the price eventually moves outside this range, it’s called a breakout.
Breakouts from a range
Breakouts indicate momentum, whether positive or negative, in the sense that the balance of power of “long” and “short” currency holders has shifted to the opposite side.
After a breakout, the price may either continue to move away from the range, usually very sharply up or down, or else the price may return back inside the range, signaling a false or failed breakout.
Breakout trading strategies work to capture the gains from pent-up buying or selling pressure that can explode when prices move outside their typical ranges.
It’s easy to see a breakout after it has already happened, yet the challenge for traders and mechanical systems is to identify and act on the true breakouts while avoiding the false or failed ones.
Trading systems must effectively manage entries into false breakouts, since they’re so common. After entering a trade, the price may rise quickly before suddenly retreating back toward or into the range. Successful systems choose only the most likely winning trades.
It’s important to keep in mind that about fifty percent of all breakouts from ranges will retrace all the way back to the breakout point before once again resuming their desired moves.
A well-built system should be prepared to re-enter a new trade immediately after a loser, if the price overcomes its correction before again moving in the desired direction. And, during a correction toward the breakout point, the ideal trading system should at least harvest a small gain even after giving back most of the paper profits.
The solution for these issues is to use a winning combination of signal filters and confirming indicators to screen prospective trades before entering positions. In particular, tools and indicators based on the angle of the moving-average line, MACD, Average True Range (ATR) and Standard Deviation (SD) are very helpful for these tasks.
Breakout trading
As mentioned above, the most important concept to understand when trading range breakouts is that half of all forex breakouts fail. So, the most successful strategies are based on avoiding entering trades immediately. Instead, the system checks for confirmation before entering any trade.
The trading system should be programmed to wait until the price first retraces to the breakout point, then begins to move in the favorable direction again. This confirmation helps the trader reduce losses which inevitably occur during frequent retracements.
Psychologically, these retracements are even harder for the trader to tolerate when he or she is first stopped out, then the correction ends and the favorable move resumes without him or her aboard. So, it’s important that the trading system should only enter a trade once the price re-crosses the breakout point.
Of course, a retracement to the breakout level only happens about half the time. Still, the gains from confirmed breakouts can be spectacular and the confidence of success after waiting for confirmation is much higher.
Regardless of the individual strategy used to trade the breakout, one of the most common ways to set profit-targets is by using a target price that is equal to the width of the range either added or subtracted from the breakout price.
Range-bound trading
During trends, small traders can often trade profitably simply by following the trend and riding along with the herd of major institutional players. However, in a trendless, range-bound market, traders need a different group of strategies. Under such conditions, trend-following systems may generate many false signals for trades which ultimately lose.
Trading breakouts and trends can be profitable, yet major breakouts are relatively rare. A given currency price typically spends about half its time moving in a trend, and the other half in a range. Traders who ignore range-bound plays are missing half the fun and profits.
Forex traders who seek more opportunities often develop strategies for trading currencies while their prices are stuck in ranges or channels, where they may remain for long periods of time.
Range-bound trading strategies work by identifying the price ranges or channels in which currency prices are confined. These strategies are based on the prediction that prices will stay within the range.
In the most basic scenario, a mechanical trading system determines the nearby support and resistance levels, then it buys when the price touches the bottom (support) of the range, and sells when the price reaches the top (resistance) of the channel.
“Pure” range traders don’t care whether a currency price is going up or down, as long as it develops and stays within a trading range.
The range-trader’s underlying assumption is that prices will repeatedly return back to recent levels. The goal of mechanical range-trading systems is to harvest the gains from this repetitive cycle, while fine-tuning gains and losses by analyzing and responding to the latest market data.
Instead of merely finding the best entry points, range-trading systems should also be programmed to be “wrong as early as possible” and with carefully-adjusted position sizes so that the trading capital is preserved for subsequent trades that arise during the repetitive up-and-down price cycles that characterize forex ranges.
Detecting range-bound markets
Ideally, the trading system should be configured to spot the earliest stages of range-bound markets. Of course, it’s impossible to precisely predict winning trades every time, but the earliest recognition of a range allows the most flexible trading response.
Here’s the main rule for assessing a given market:
If the market isn’t obviously trending, it should be treated as a ranging market
With regard to technical indicators, when the chosen indicators stop showing clear signs of a distinct price trend, the trading system should assume the market is entering into a new range-bound period.
One of the easiest ways to spot a range-bound market is by checking the angle of a Moving Average (MA), generally by using a Simple Moving Average (SMA). For example, if the SMA is rising quickly, then the angle of its price line compared with the time axis will become steeper.
Likewise, if the angle is becoming lower, the trend is becoming weaker. If the angle is flat or near-zero, then the market is range-bound, or very sleepy.
Trading systems can be programmed with indicators built to compare the steepness of the angle of the current SMA against its “normal” steepness during different market periods. These indicators can be set to respond with various degrees of sensitivity to changes in the moving-average angles.
Another easy way to detect ranging markets is a Moving Average Convergence/Divergence (MACD) indicator. This type of tool works well in real time, especially when markets are volatile.
By adding two levels to the indicator – lower and upper horizontal lines below and above “0” on the MACD, trading systems can spot levels at which prices are most likely to consolidate.
In the chart below, the principal ranging zone is shown inside the green box. And, inside the box I’ve highlighted the ranging areas between the 0.05 and -0.05 levels. These are the tradable areas where the trading system detects a ranging market in real time.
As well, the MACD-based range-bound zone can be adjusted to values such as 0.03 and -0.03 or another value that the trading system determines to be appropriate for a given market. An expert advisor (EA) can help define the appropriate levels by examining historical levels in particular markets.
In any case, the MACD histogram hanging around the zero level indicates a ranging, tradable market.
Although naysayers may claim that this method doesn’t show the entire range until after the sideways movement has ended, your trading system doesn’t need to wait that long. When the MACD first enters the ranging zone, you’ll have plenty of warning that a range-bound market is about to occur.
Once the MACD enters the zone, the trading system can monitor the price and use additional confirmation tools to confirm that the range is still intact before trading. This MACD-based method can be very helpful in combination with other indicators.
Using Average True Range and Standard Deviation to spot trading ranges
As indicated earlier in this article, ATR and SD are helpful in highlighting trading ranges which can be exploited.
Shown in the EUR-USD chart below are two indicators, the 14-period Average True Range and the 14-period Standard Deviation, which can be used as tools to discover potential trading range areas.
In one indicator scenario, for example, when the 14 ATR is greater than the 14 SD, it indicates a ranging market. And, when the 14 ATR is less than the 14 SD, the market is trending.
From one perspective, the apparent logic behind this indicator is that the ATR shows the shorter-term daily volatility while the SD represents volatility over a longer period of time; although the market stops trending, the intraday volatility may stay the same, or slow down even more.
In another simple strategy, the trading system can simply monitor whether both ATR and SD are pointing upward. If so, the market is trending.
Also, savvy traders can build trend-strength indicators based on calculating a rate-of-change ratio between the current ATR and SD values using the desired time-frame. These indicators are useful for showing ranges as well as breakouts.
The usual default number of periods is 14, and Fibonacci-lovers often use 21. Still, as a rule, the shorter the trading system’s time-frame, the greater the number of periods should be.
If the ratio is increasing, it means the trend is becoming stronger. Or, if it’s dropping, it means the trend is weakening and will soon become either a range or a reversal. If the ratio is at the bottom, it indicates a ranging market.
In summary, there are a variety of ways for forex traders to determine whether a market is in a range, breaking out or trending.
Regardless of the strategy employed, traders can feel right “at home on the range” once they’re able to identify ranges and thus have more opportunities to trade them.
What’s your own trading style? Are you a range trader, breakout specialist, or trend-follower?