The Best Market Environment for Retail Forex Traders

07/18/2014 9:00 am EST

Focus: CURRENCIES

James Stanley

Trading Instructor, DailyFX Education

Even though most traders prefer trend trading to range bound trading, James Stanley of DailyFX.com doesn’t think the range bound market condition should simply be ignored.

The trending market condition is often preferred by traders because of the huge upside potential coupled with the ability to enter positions relatively cheaply (tight stops when trying to catch swings).

But the fact-of-the-matter is that trends are the exception rather than the rule. By most accounts, markets spend a large portion of the time ranging back-and-forth; and depending on who you listen to or which market you trade—this deviation can be more or less pronounced.

But is this a bad thing? Many traders run away from range-bound markets as if they’re infected with the plague…but is this market condition one that should be ignored?

In this article, we’re going to do our best to tackle the range.

Why Traders Should Include a Range-Approach in their Arsenal

Traders should, at the very least, learn to analyze ranges for one big reason: Consistency.

It’s pretty baffling to hear newer traders complain about a lack of volatility. Volatility is synonymous with risk…so when I hear this, it’s like hearing someone say ‘the market isn’t risky enough.’

Well—make no mistake about it, any market you trade is always bearing risk(s). Perhaps sometimes more than others, but think about this for a moment…

As volatility (risk) increases, so does the unpredictability of price movements. So while everyone in the world might want to trade EUR/USD during NFP, the fact-of-the-matter is that it’s not likely to be a high-probability play.

Further to that point—those high-risk periods in the markets can make it extremely difficult to manage risk. Your stops will get hit quicker, prices will reverse faster than normal; and if you’re bold enough to go into a news trade without a stop: Good luck, because you can watch 50% of your equity go up-in-smoke quicker than Janet Yellen can shout ‘more QE!’

The range is more calm, more consistent, and all-in-all usually a more comfortable way to manage risks. But you don’t have to take my word for it…

We originally wanted to see which trading session was best for retail traders, so David Rodriguez ran profitability statistics for retail traders based on time-of-day. The deviation was very pronounced, as the Asian trading session was far-and-away the most profitable time of day for retail FX Traders.

The deviation was so pronounced that we wanted to find out why…

So, David then looked at volatility levels during each of these trading sessions, and this is where the deviation began to make sense.

Volatility, in general, is lower during the Asian trading session. This means that price movements are, in general, smaller coupled along with a higher degree of respect for support and resistance.

Higher-volatility periods such as the European session, or the US session, saw far less profitability amongst retail traders; and one of the primary reasons is because of the higher levels of volatility brought on by news releases and data announcements made these speculators even more vulnerable.

So, if a trader enters a trade and places a stop for a long position underneath support (or stop for shorts above resistance)—this means that the trader can have a greater chance of seeing the stop respected in a lower-volatility environment, like a range.

But does this mean that all traders should stop what they’re doing to rebuild their trading plans so that they can focus on range-bound markets during the Asian trading session? Absolutely not…this merely means that traders should have a way of trading range-bound markets because it can be a more amenable environment, especially for newer retail traders that lack the experience to be consistently profitable during the ‘manic’ times in the market. This is simply another arrow to add in your quiver.

NEXT PAGE: Don’t Let the Arrow Fly Just Yet

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How to Trade Ranges

Just as in any of the three conditions, there are quite a few ways to go about speculating in that environment.

The basis of a range-approach is support and resistance—and the ability to see prices move between those two boundaries.

This support and resistance can come into the market from a variety of ways.

It isn’t enough to simply identify the price level and say ‘well, that’s support,’ or ‘that is resistance.’ To validate the level, traders want to see an actual reaction taking place around that price. This is the great part about price action: It isn’t esoteric, nor is it theoretical. Price action is simply noticing that buyers had entered the market at a certain price—thereby supporting that market at that price level—or the fact that sellers had come in as a new, higher prices were offered, thereby resisting in that market. There’s an excellent example of a range right now in USD/JPY. Since dropping below 104 on January 23 of this year, the pair has been caught between support and resistance. The chart below is the daily chart in USD/JPY, with the range annotated:

The Current Range in USD/JPY (Daily Chart)

chart
Created with Marketscope/Trading Station II; prepared by James Stanley
Click to Enlarge

Notice how after establishing support at 100.70, the pair has stayed confined between this price level and resistance of 104.10 for well over five months; continuing to oscillate between support and resistance.

We can also notice how traders weren’t quite willing to wait for prices to move all the way down to 100.70 before buying, or up to 104.10 before selling…quite a bit of support and resistance took place slightly inside of each of these levels; making support and resistance more of a zone as opposed to a hard-set-and-fast horizontal price level.

Also notice how much of this support or resistance inside of these peak levels showed up around psychological support and resistance. This is the power of confluence showing itself in this range of USD/JPY.

After filling in the zones of support and resistance, we can begin moving a step closer to an actual strategy for trading around this range:

Price Action can help to show Support/Resistance as a Zone—USD/JPY 4-Hour Chart

chart
Created with Marketscope/Trading Station II; prepared by James Stanley

Click to Enlarge

Created with Marketscope/Trading Station II; prepared by James Stanley

This is the Reason that Ranges can be So Beneficial to Traders

After we’ve added our zones, we can then decide how, when, and where we want to look to buy and sell. And the best part about the range—there is no guesswork. The below image shows how traders can build a strategy based on what we’ve already looked at:

Building a strategy for trading the range (USD/JPY 4-Hour Chart)

chart
Created with Marketscope/Trading Station II; prepared by James Stanley

Click to Enlarge

Because support and resistance has been confined between 100.70 and 104.10—we know that if prices breakout of that range, then the environment that we’re looking to speculate in (the range) is no longer valid.

So why would we want to sit in a short position while USD/JPY rips up to new highs at 106 or 107? We wouldn’t!

Or further—if USD/JPY breaks below 100.70—would we really want to be sitting in a long position with the expectation that the range might come back even though prices have broken out to the downside?

The best part about trading the range is that risk is always defined. This doesn’t mean that prices can’t break support or resistance only to see prices come back into the range-bound patterns…but it does mean if you see a break, you can have a level of confidence in closing out the trade in an effort to avoid losing more than absolutely necessary.

Further to that point—there is no guesswork with profit targets. If you’re trading a range and you bought when price was at support and price is now at resistance—you can, once again, take a degree of confidence into the act of closing out the position.

So while trends have the constant question of whether or not we’ve hit the ‘higher low’ or ‘lower high,’ and breakouts are constantly bombarded with questions of legitimacy, the range can be expected to continue until something changes. The luxury of having a defined-risk profile in the strategy makes the condition even more attractive; and if you combine that with the fact that range-bound markets are the most common condition—having a mannerism of attacking the range becomes a very sensible fact.

By James Stanley, Trading Instructor, DailyFX.com

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