Pros, cons and common mistakes of range trading

New traders might ignore range trading because ranges seem limited by how much a price is likely to go up or down before returning to its historical average (as opposed to a trend, which might see much bigger price action). However, the advantage of trading in a range is that it comes with clear risk management.

If the range breaks and you're on the wrong side of the move, you can quickly exit knowing that the market is changing. You don't have to keep second-guessing yourself because the market condition you were speculating on, a range, turned out to be wrong.

Pros and cons of range trading

Advantages:

Easily defined entry and exit points: Range trading provides clear entry and exit points based on support and resistance levels, making it simpler for traders to plan their trades
Manageable risk: Because traders aim to buy at the lower end of the range and sell at the upper end, they can set tight stop-loss orders within the range, thus limiting their potential losses
Predictable price movements: In a ranging market, prices tend to move within a relatively stable range, allowing traders to anticipate price movements and make informed trading decisions
Multiple opportunities to trade: Range trading works well in markets that are consolidating or moving sideways, providing opportunities for profit even when there is not much volatility or a clear trend. Plus, the back-and-forth price movement within a range means there are likely several trading opportunities available

Disadvantages:

Limited profit potential: Compared to trending markets, ranges generally offer lower profit potential because the price movements are smaller
Not suitable for volatile market conditions: Range trading may not be suitable in strongly trending markets where prices are consistently moving in one direction, as traders may find it challenging to identify clear support and resistance levels. Traders also need to be patient as they need to wait for price to reach support or resistance levels before entering a trade. This can result in missed opportunities during fast-moving markets
Vulnerable to fake outs and whipsaws: Ranges can be short-lived and traders must therefore be cautious of false breakouts, which can trigger stop-loss orders before the price reverts to the range. A sudden shift in market sentiment can also expose traders to whipsaws

What is a whipsaw?

A whipsaw is when a trader is caught in a rapid succession of losses due to sharp and unexpected reversals in the price of an asset. It happens when a trader takes a position based on a particular direction of the market, but the market quickly moves in the opposite direction, triggering a loss. Shortly after, the market reverses again, moving back in the initial direction, thus causing another loss for the trader. This back-and-forth movement resembles the motion of a whipsaw, hence the term. Whipsaws often occur in volatile (choppy) markets where there is no clear trend or when there is sudden news or market sentiment changes.

Example

Imagine you’ve just opened a long position on the ASX 200, having identified that the price has consistently ranged between 7,800 and 8,000 points. Based on your technical analysis and historical price movements, you decide to go long and to buy the ASX 200 index futures contract when the price reaches 7,900 points, expecting a bounce back up within the range.

However, shortly after you enter the trade, unexpected news causes a sudden downturn in the stock markets. As a result, the ASX 200 index quickly drops below the support level at 7,800 points, triggering your stop-loss order and resulting in a loss on your long position.

You now anticipate further decline in the market, and you decide to short the ASX 200 index futures contract as it falls below 7,750 points.

However, unexpectedly positive economic data is released that contradicts the earlier news, sparking a sudden rally in the markets.

The ASX 200 index quickly reverses direction and surges back above 7,800 points, again triggering your stop-loss order on the short position and resulting in another loss.

Are there any common range trading mistakes I should try to avoid?

Every trader gets it wrong sometimes. In fact, we have a three-part series on common trading mistakes in our course on trading psychology. When it comes to range trading specifically, here are a few common pitfalls you should try to avoid:

1. Trading against the prevailing market conditions. For example, trying to initiate trend-following trades in a ranging market or expecting breakouts when the market is consolidating.
2. Failing to accurately identify range boundaries. This can lead to poor trading decisions. You may enter trades too early or too late, resulting in losses or missed opportunities.
3. Overtrading within a range. Traders may be tempted to enter several trades within a narrow range, hoping to capitalise on small price movements, but overtrading can lead to increased transaction costs and reduced returns.
4. Inadequate risk management. When traders fail to set appropriate stop-loss levels or position sizes, they expose themselves to excessive risk.

Did you know?

When implementing risk management, you can consider using trailing stop-loss orders. A trailing stop is a stop that automatically adjusts to market movement. This means it will follow your position when the market moves in your favour, and lock in your profits and close the position if the market moves against you. Read more about trailing stop-loss orders and how to set them here.

5. Ignoring fundamental analysis. While technical analysis is critical to successful range trading, ignoring fundamental analysis can mean traders neglect to consider broader market factors, economic releases, or news events that could impact price movements within the range.
6. Lack of patience. When traders get impatient, they take unnecessary risks, such as trading before accurately identifying range boundaries.

You might also want to:

Assess the risk-reward ratio for each trade to ensure that potential profits outweigh potential losses. Aim for a favourable ratio (1:2 or higher) by setting profit targets at least twice the distance to the stop-loss level and adjust your profit targets based on the size of the range and market conditions
Diversify your trade selection to avoid concentrating your trades on a single asset or currency pair. This helps to reduce the effect of adverse price movements on your overall trading performance

Steering clear of common problems is much easier when you implement “good trading hygiene”, such as setting a clear trading plan and sticking to it, implementing proper risk management and keeping a trade journal to assess and improve your trade performance.