The following traders - Range-bound Traders, Channel Traders and Breakout Traders - are linked in many ways, either in their trading strategies, styles, formats, or disciplines, as well as the fact that they rely on the trade being harnessed between two fairly recognizable lines. Obviously the breakout trader is looking for the moment that these lines are broken.
A. Range-bound traders
Range-bound traders use a purely technical method of predicting a stock's short-term highs and lows. Obviously, this type of trader is more active in range-bound markets, where they trade stocks within a defined channel.
A range-bound market is observed as a trading strategy that identifies stocks trading in channels. By finding major support and resistance levels with technical analysis, a range-bound trader buys stocks at the lower level of support (bottom of the channel) and sells them near resistance (top of the channel).
The trader looks for stocks with a clear support and resistance level - see "Strategies for a Range-bound Market" below. The trader then buys at the support and sells at the resistance. The simplest way for the trader to create a channel is to connect a number of high chart points as well as a number of low chart points. The resulting channel is the range within which the trader operates.
Example of range-bound trading with Google Inc. (Nasdaq: GOOG)
Trading range-bound stock can be a great short-term money making opportunity by shorting and going long within the range.
The trader may repeat the process of buying at support and selling at resistance many times until the stock breaks out of the channel. The upper boundary of the channel is shown by a trend line that connects the points representing a stock's highs over a given time period. The lower boundary of the channel is identified by connecting the points representing a stock's lows.
The downside of this strategy is that when a stock breaks out of the channel, it usually experiences a large price movement in the direction of the breakout. If the breakout direction is not favorable for the trader's position, bad losses can occur.
There are three types of channeling stocks or rolling stocks, some might say:
1. Ascending - Stocks bounce up and down the channel in an uptrend.
2. Descending - Stocks bounce up and down the channel in a downtrend.
3. Horizontal - Stocks bounce up and down support and resistance levels in a horizontal trading range.
Strategies for trading range-bound stocks:
1. Go long just above the high of the first bar, when stocks bounce up from support line.
2. Go short just below the low of the first bar when stocks bounce down from resistance line.
3. Go long when stocks breakout of the channel to the upside.
4. Go short when stocks breakout of the channel to the downside.
5. Look for obvious points of support and resistance where buyers stepped in to move the stock back up and where sellers stepped in to drive the price back down. Once those two points are established, there is a high probability that the points will be held again in the future.
6. This range-bound movement - also known as channeling - will eventually break but there are usually two or three good trades before that happens.
7. The range-bound movement usually occurs at the end of a large move as the bulls and the bears fight over the direction of the next move. The range can revolve around past gap support or gap resistance, moves from above to below major moving averages.
A range-bound market offers various opportunities to profit in this market. In this example, the trader is able to use the zigzag motion to their advantage, by simply identifying major support and resistance levels, and then buying at the support level and selling at the resistance. There are various technical indicators that can help determine times of entry and exit points - like stochastics and relative strength index - that indicate overbought and oversold areas. A range-bound trader can use these areas to trade stocks that move within a range.
Besides buying and selling stock, other trading strategies a range-bound trader can use are spread betting, CFD (contract for difference) trading and options trading, to name a few.
A range-bound trader's strategy requires fairly constant monitoring of the stock, because a stock that breaks out of a range may make a dramatic and sudden price move.
Strategies for a range-bound trader
In the range-bound market, stocks spend as much as an estimated 80% of the time doing very little. And that means most of the time, investment money is just sitting there, trapped between short-term support and resistance.
In a range-bound market, support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy, and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support. If a stock's price falls below current support, it may signal a declining trend to a lower trading range.
Recognition of key support and resistance levels is essential for successful technical analysis. Although it is sometimes difficult to establish exact support and resistance levels, being aware of their existence can greatly improve analysis and forecasting power. Channeling or trading ranges plays an important role in determining support and resistance as turning points or as continuation patterns.
“Discipline never goes out of style.”
B. Channel Traders
Channel trading is a powerful yet often overlooked form of trading that capitalizes on the tendencies of markets to trend. It is the technical range between support and resistance levels that a stock price has traded in for a specific period of time.
The channel trader combines several forms of technical analysis that provide precise points from which to buy and sell, put stop-loss and take-profit levels, etc., to take advantage of the trending market.
In the context of technical analysis, a channel is defined as the area between two parallel trend lines and is often taken as a measure of a trading range.
A trading channel is created by charting the price of an asset, such as stock or commodity futures. Two parallel trend lines are drawn on the chart between the asset’s support and resistance. The upper trend line links price highs or closes. The lower trend line links the price lows or closes. The area located within the two lines is known as the trading channel. The price remains within this defined space until a channel breakout, or price breakout, occurs in either direction. The trading channel gives traders a visual look at the trading range of an asset for a certain time period.
An example of a channel is shown below. Breakout points in channels indicate bullish (on upward trends) or bearish (on downward trends) signals.
1. Channels are useful for short-to medium-term trading - not long-term trading or investing. The technique often works best on stocks with a medium amount of volatility. Remember, the volatility determines the profit per trade. Channeling also tends to work best when the technique is combined with other forms of technical analysis.
2. A breakout of a technical channel is seen as a bullish (on an upward breakout) or bearish (on a downward breakout) signal.
Once a price channel has been identified, identifying areas to trade becomes a very straightforward proposition. Trading pricing channels is much like trading a range by pinpointing areas of support and resistance for out entries.
Typically, channel traders will sell an asset when the price approaches the top, which is the resistance level. Conversely, traders will buy an asset when the value gets close to the bottom. This is the support line. Many channel traders consider the trading channel to be a very reliable technical analysis tool for defining trend behavior. The trend lines are actually an aggregate of traders’ belief about the value of the asset. Trading channels illustrate the boundaries of this changing sentiment as values back away from resistance and springs off of support.
In a descending pricing, channel traders will look to sell the market on a test of resistance. Traders will look to sell in this gradual downtrend and take advantage or price reaching to lower lows. It’s important to understand that trading channels is ultimately a support and resistance strategy. That means that traders will wait for their opportunity to enter the market and not trade when prices reside between these levels.
Example of a channel trade - Whitecap Resources Inc. (TSX: WCP)
Whitecap Resources was trading in a steady bullish channel as of August 7, 2013 and represents a favorable opinion that there will be a continuation of this trend.
Target Price: C$12.68
Potential Profit: 13.22% (based on an entry price of C$11.20)
Stop Loss: C$10.72
The company’s fundamentals are still strong. Sales are estimated to be up +48.7% for one year. Analysts from Thomson Reuters consensus have made a large upwards revision of their EPS estimates. The last EPS was at C$0.45.
From a technical viewpoint, the security is trading in a bullish trend on all time scales. Increasing moving averages would make it unlikely that there will be a reversal in the coming trading sessions. The 20-day moving average should help to reach the C$11.20 long-term resistance quite soon. Above this threshold, a buyer enthusiasm would occur to lead the security towards the upper limit of the bullish channel.
Thanks to these good indicators, it seems relevant to take a long position in Whitecap Resources on crossing the C$11.20 resistance. The target price is the C$12.50. A stop loss will be set under the C$10.80 short-term support because a breakdown of this level would damage the technical pattern.
Variations of channels
There are a variety of trading channels, such as horizontal or sideways channels, which can be found in markets that are trending up or down. These types of channel are not necessarily an indication that the prevailing trend is changing, but is indicative of a market that is in a resting or consolidation phase. This often occurs before the market makes its next move. Usually, the price breakout happens in the direction of the prior trend. To create a horizontal channel, draw a straight trend line that touches the most recent price high and a straight line that touches the asset’s price valley during the same time period.
There is not an existing rule or predetermined number of times that a price must meet the channel lines before traders should make buy or sell decisions. However, most traders look for at least two high points and two low points to validate a particular formation. Regardless of the trend, it is essential that both the trend and channel lines are drawn parallel to each other. Drawing the lines at the wrong angle will yield false conclusions. Traders typically anticipate where prices will go by computing the distance between the lines.
Regardless of your trading strategy, traders should always have a plan to exit the market. One of the benefits of channel trading is that stop and limit levels are built around the previously defined levels of support and resistance. In a downward sloping channel, stops should always be placed above a level of resistance. In the event that price begins printing higher highs, traders will want to exit positions to sell the position as quickly as possible.
Profit targets will be set using the support line of the pricing channel. Traders will extrapolate this value by extending the line on the graph. Traders will want to exit positions with a limit order, when price touches this area of support. If the channel is to continue, price may bounce back to resistance at this point, continuing the descending charting pattern.
C: Breakout traders
Breakout traders are looking for strong stocks. They buy when a stock has just broken out and follows it up because breakouts on high volume are normally a strong buy signal, especially in bull markets. These traders can sometimes find stocks that move astonishing amounts in short periods of time.
These breakout traders often have their own sets of rules to help determine if a breakout trade is a false signal or a great buy. They may decide to add fundamental analysis or other indicators to help weed out breakouts that produce false signals.
Typically, the signals for breakout trades occur when volatility increases with prices rising above (or falling below) their historical ranges. Using proper money management techniques, breakout traders are able to limit risk and capture significant price moves before most of the rest of the market traders are even aware of the newly developing trend.
Definition of a breakout trade
A breakout is what occurs when stock prices (or prices for any other asset class) exceed previously determined support or resistance levels. Long positions are triggered when prices move above resistance, while short positions are signaled when prices drop below a clearly defined level of support. Since these breaks are uncommon (and usually unexpected) other market traders are typically caught off-guard by the price activity and, as a result, volatility will generally increase. Another reason for this increase is that traders with range-trading strategies often have stop losses just outside of the commonly defined range, and when the break out triggers these stop losses, prices have the potential to gain momentum in the direction of the break.
A typical example of this type of action can be seen on the chart below of Priceline.com Inc. (Nasdaq: PCLN).
It should be noted that breakouts can occur on any time frame, but those seen on the longer term charts tend to create more significant changes in momentum and volatility (which suggests a higher level of forecasting ability and successful trading). The same rules apply on any chart time frame, but breakouts seen on a daily or monthly basis generally have a higher probability of showing a true change in underlying trends (which suggests a higher level of validity in the breakout price movement).
Breakout trading strategies
A breakout is a stock price that moves outside a defined support or resistance level with increased volume. A breakout trader enters a long position after the stock price breaks above resistance or enters a short position after the stock breaks below support. Once the stock trades beyond the price barrier, volatility tends to increase and prices usually trend in the breakout's direction.
The reason breakouts are such an important trading strategy is that these setups are the starting point for future volatility increases and large price swings. In many circumstances, breakouts are the starting point for major price trends.
When trading breakouts, it is important for the breakout trader to consider the underlying stock's support and resistance levels. The more times a stock price has touched these areas, the more valid these levels are and the more important they become. At the same time, the longer these support and resistance levels have been in play, the better the outcome when the stock price finally breaks out.
Typically, the most explosive price movements are a result of horizontal channeling. In this type of channel, support and resistance level is more evident to traders. With this breakout strategy, breakout traders are tested in the fact that they have placed their limit orders above the line of resistance or below the line of support. When price breaks through this level, limit orders are automatically filled. This results in increasing volume.
Methods employed to find breakouts
Breakout traders scan for stocks that have the following setups:
- Bollinger Band width index of three or less, preferably less with a candlestick count of 20 or more, preferably more.
- It should have low volume indicating the "calm before the storm." The ones where volume has clearly fallen off are the ones that have the most potential to "explode."
- The five, 10- and 20-day EMAs have truly converged.
- Defined support and resistance.
- By using a technical indicator called ADX, (average directional movement) and looking for periods where the ADX has breached below a threshold level.
- A relatively narrow trading range over X units of time is apparent - for example, a program might scan for when the seven-period range is low relative to recent seven-period ranges.
- Have identified a sequence of bars (three or more) where the market closes within a prior bar’s range.
When these areas are recognized it is important that the breakout trader has precise protocol for identifying a signal and entering the market, and then managing the trade. All too often, traders believe that just understanding a setup will allow them to trade it profitably. This is false!
Breakout traders use price resistance lines in their charting. Price resistance is one of the best types of resistance lines because it carries a psychology behind it.
The psychology behind price resistance definitely helps breakout traders to make more profit from their trades.
When a stock is on the way up, there are always people buying shares, and all the way into the top. Once the selling starts (because the people at the bottom are taking profits) it leaves the traders who bought at the top holding their shares. These traders are called bag holders, and it is never a good idea to be a bag holder.
The biggest problem for traders is taking a loss. Instead of selling out for a small loss, these traders will hold onto their shares and trade with “hope."
First, they hope to get out with a profit, but once the selling picks up, they will just hope to get out at break-even. When the stock begins to make another run, all these bag holders are waiting to get out at break-even.
When all these traders dump their shares around the highs, it creates a price resistance at that level. When the majority of bag holders have dumped their shares, a break of this resistance level is seen and breakout traders can now return to buying the stock.
Example: In this chart of Amgen (Nasdaq: AMGN), it is obvious that it has been making a big run during July. It stalled out for most of the preceding week, but then made a big move again and is set up for a breakout.
As you notice through the chart, people were buying Amgen as it ran from $90 to $112. The people who bought in the $100 territory quickly realized that they were buying at the top as Amgen began to sell off. When the stock hit $109.68 again, it stopped, and price resistance was formed.
How do we make money from this?
Breakouts are best played close to the price resistance line, in this case $109.68, barring the last day of $112.40. Traders want to buy this stock at $109.70 because this keeps the risk lower on the trade. The target should be the next resistance line up at $115, which is good for 4.5%.
The key to successful breakout trading is seeing a follow-through (or a continuation) of price activity in the direction of the break (a break of resistance for a long trade, a break of support for a short trade). Without this momentum, prices will reverse and stop breakout traders out of their position.
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