Trading Range: Definition and Duration
For some of you it might be useful to start by explaining what a “trading range” is and then carry on with the strategy itself. A range occurs when an instrument, no matter whether it is a currency pair, an index or a futures, keeps on trading between a well-defined resistance and support line, i.e. between a high and a low.
Depending on the chart frame, ranges can take anything between minutes and years until either the support, or the resistance is violated, and duration is something important for speculators. Large trending moves quite often precede extended range-bound periods. As you can see on the chart below, the brutal sell-off that took the EUR/USD from just off 1.4000 all the way down to 1.0460 in 2014 and early 2015, was followed by a range that continued more than two years and a half. The latter finished in 2017 with a violation of the upper boundary, which resulted in an impulsive wave up.
The Strategy Itself
Let us observe the EUR/USD chart in the depicted period more closely. The upper bound of the trading range is roughly between 1.1450 and 1.1500, while the lower end is in the 1.0500-1.0450 area. The strategy implies buying the forex pair when it approaches the support and selling as it reaches the resistance. It is important to note that one should not wait for the instrument to hit 1.1500 to sell and 1.0450 to buy, as in most cases the move will reverse short of reaching the extreme point itself. Technical indicators like stochastic oscillator, relative strength index (RSI) and the commodity channel index (CCI) can be helpful in timing the entry, as they confirm oversold and overbought conditions.
The Need For Stop Loss Orders
A key aspect of this strategy, and in leveraged trading in general, is the use of stop loss orders. The latter are the key risk management tool and an absolute must if one wants to protect his capital. When going short close to the upper boundary of the range, stops should be placed a few pips above 1.1500. Stop orders on long positions, taken near the lower end, need to be placed below 1.0450.
As you can see, on a couple of occasions, in August 2015 and in May 2016, stop losses would have been triggered if placed firmly above 1.1500. However, the price action has returned back into the channel within the same time period (the chart is weekly). In trading, this is known as a false breakout and is a risk every speculator is running. Once confirmed that the violation of the support or resistance was fake, one could open the trade again: in this case go short, and place his stop loss order above the new high; in August 2015, this was 1.1713, and in May 2016: 1.1616.
You might ask, what necessitates the use of a stop, if there is a risk of a false breakout. The same chart is quick to give the answer. In the summer of 2017, the EUR/USD stages a confirmed breakout through the upper boundary. What happens afterward is a sustained rally that brings the forex pair to 1.2555 in a matter of several months. Such a strong impulsive move would have resulted in severe losses or even in a complete wipeout of the trading accounts of those stubbornly insisting on their short positions.