By Martha Stokes, C.M.T. © copyright 2007 all rights reserved.
Trading Range Market Conditions require a different approach to trading than a trending, or correction phase market. OF the four sideways trending patterns, the trading range has the widest point range. It also tends to last a much longer time than other sideways patterns. This makes sense when you consider what kinds of economic and business conditions help to create trading range sideways trends.
Understanding the conditions behind the price action:
During trading range markets, the economy is in a stall and companies are struggling with inconsistent earnings and revenues. This creates a seesaw, up and down price action from quarter to quarter as earnings and revenues oscillate between improvement and setback. Stocks and indexes can stay in a wide loping trading range for years, so long as the financial and economic conditions are stagnated. W e saw this in the 70’s for the Dow 30 Industrials. This monthly chart clearly shows a stable trading range market condition that started in 1965 and ended in 1983. The trading range is well defined with reliably consistent highs and lows that remain within the range established by the low in 1962.
George Lane wrote his popular Stochastic indicator during the 1960’s and it is widely used by traders for trading range market conditions And you can see clearly the oscillation pattern as the Dow trends in a sideways trading range for all those years.
In the chart above, the Dow 30 Industrial Average once again experienced a trading range as the industrial stocks on this average stalled as the NASDAQ technology Exchange took off in its final speculative uptrend. Again this trading range is remains reasonably contained within its high range and low range. However, instead of breaking out to resume an uptrend, this trading range collapsed into a steeper triple bottom before returning to the trading range price area for another few years.
Oscillators were designed specifically for trading range markets and work ideally in these market conditions. Nearly every trader should use at least one oscillator to evaluate overbought and oversold conditions in stock prices, and most attempt to sell at the overbought pattern and buy at the oversold pattern.
But a far more critical aspect is usually missed entirely.
At some point, all trading ranges will come to an abrupt end will either breakout to the upside with a strong rally, or breakout to the downside with a strong downtrend. Oscillators are often the first indicators to signal a breakout, yet most traders do not see these leading patterns in their oscillators.
Unfortunately, few traders know how to read oscillators to find breakout patterns from that trading range. Without the ability to interpret oscillator patterns that indicate a breakout is imminent, most traders who use oscillators exit just prior to a major price move out of that trading range, thereby losing huge profit potential.
A trading range by its very nature is a period of indecision but also a time when stocks are resting, gathering energy or losing energy based on the condition of the company. If the company is reinventing after reaching market saturation on their products or services, then the stock will begin to gain energy even before it breaks out of that trading range. Oscillators such as Lane’s Stochastic, Wilder’s Relative Strength Index, Worden’s Price Rate of Change, or any other Price Oscillator can be used to analyze whether the trading range is gaining strength or if it is weakening which indicates the company is moving further into decline fundamentally. Technical analysis when used properly can expose fundamental weakness or strength even while stock prices are stuck in a trading range pattern.
How the theory works:
Price Oscillators are primarily written based on the theory of buyer demand or seller demand. The theory behind stochastic for instance is that as a stock moves up in price it will close near its high for the day so long as buyers are dominant. When it begins to close further and further away from its high, then this signals that there are fewer buyers and the price begins to close lower and lower. This is an overbought condition and most price oscillators will begin to turn down signaling traders it is time to sell or time to sell short.
However, when a stocks or an index is about to have a sudden breakout from a trading range, oscillators reveal a distinctly different pattern from the typical overbought oversold oscillation on a chart.
You can see that Stochastic is forming higher lows even while Dow 30 continues to be stuck in a trading range. And as it nears the overbought line, it then begins to float as the stock moves with momentum. This is what I call “a floating pattern stochastic” and it signals a strong continuing rally.
Wilder’s Relative Strength Oscillator also reveals a similar floating pattern with higher lows prior to a breakout from the trading range. RSI was written in 1978 during the trading range market of those years.
Similar floating patterns appear on other indicators such as Commodities Channel Index, a cyclical indicator. The CCI has a floating pattern during the strong uptrend that followed.
Oscillators are wonderful tools for trading range markets, but traders should also watch for the oscillator patterns that precede strong breakout patterns to the upside and downside. By watching for oscillator patterns a trader can watch for higher lows that move over or near the overbought line and then turn horizontal to begin the floating pattern typically seen during strong momentum runs for all oscillators. Conversely when a trading range is about to break out to the downside, the oscillator will make lower highs then move beyond or around the oversold line and shift to a horizontal pattern.
By using oscillators not only for overbought and oversold signals, but also for breakout signals, the trader expands the usefulness of the oscillator indicator tool. Not only can an oscillator be used for a trading range market but also to anticipate the breakout rally or correction that follows a trading range market condition.
The floating oscillator helps a trader hold during strongly trending markets when normally a trader would exit based on the assumption that the stock is overbought or oversold. Recognizing the floating pattern is an important skill for all traders to develop.
Which oscillator you choose is a decision you must make based on your individual trading style and indicator toolkit. Each will have a slightly different floating pattern and settings and periods will need to be tweaked from time to time to expose these patterns optimally.
Martha Stokes, C.M.T. is the Senior Technical Analyst and co-instructor for TechniTrader, the educational division of Decisions Unlimited. Stokes’ courses teach swing, position, options, intermediate, and long term trading and investing. In her 25 years of teaching and trading, Stokes has developed all of the material featured in this series and writes for various paper and internet publications. She also authors daily and weekly newsletters for all of her students on market condition and in-depth analysis of stocks, trading techniques, and strategies. For more information on TechniTrader’s courses, go to www.TechniTrader.com or call 888-846-5577.