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Stock Trading Strategy: Range Trading

We have already enumerated the four basic stock trading strategies. To review refer to the following posts:
How to Develop Your Stock Trading Strategy, Pt. 1
How to Develop Your Stock Trading Strategy, Pt. 2

We have also discussed the methodology behind the buying on pullbacks stock trading strategy:
Stock Trading Strategy: Buying on Pullback

In this post, we will discuss the Support/Resistance or Range Trading Strategy. The first thing you need to know is when to apply this strategy. You apply this strategy when you have confirmed that the stock has entered a range/consolidation. This is also known as an area pattern. Usually a consolidation/area pattern comes after the stock hits resistance, churns near resistance (which is when we apply the daytrading/scalping strategy), and breaks the shortest-term support on the daily chart. Take a look at the sample chart of BIDU below.


Another confirmation that we have entered the a consolidation period, thus a range trading strategy, is when the MACD does a crossover to the downside (loss of momentum) and corrects to OR near the zero area (momentum, though it has waned, is still positive). Basically this means that the stock has already achieved its magnitude in terms of its move, and needs duration or time to make up for any exaggerated moves. This is why the stock goes into a consolidation period and thus we trade the ranges.

The range trading strategy is similar to the buying on pullback strategy, the only difference is that the buying on pullback strategy is pulling back from a new high, so it has enough momentum to SOMETIMES rise above resistance and into a new high. In a range trading strategy, it sometimes is pulling back from a new high but you find out after the first bounce that its momentum is not that strong after it doesn't go into a new high. The buying on pullback strategy also doesn't fall below the 32-day moving average. For range trading strategy, you also have the tendency for the stock to churn longer at resistance (trapping more buyers) before the initial pullback, thus leading to the consolidation period.

The following are the steps to support/resistance or range trading strategy.
1) After pulling back from resistance, look for a support level. It could be either a moving average, parabola, a previous support, or a trendline.
2) Once it reaches support level, let the stock churn for at least 2 days to a week. If the support is at the 32-day moving average, it churns for a shorter period of time, at most 3-4 days. For 65-day and 130-day moving average, it could possibly (but not all the time) churn longer.
3) If the stock is holding at the 32-day moving average, it is preferable that the slow stochastics reading is below 20. However sometimes it is a little above 20.
4) Once in that churning area, identify the resistance level of that churning area.
5) If possible, try to identify the bigger area pattern that is forming. Read more on classic charting patterns at the chart school at www.stockcharts.com. Usually, you don't get to identify this until it finds a resistance level after the first rally from support. This is so you know what support level to buy the next time it retraces to the support area of the area pattern.
6) Buy the stock on the break of that resistance, targeting the resistance of the bigger area pattern.
7) Compute your stock trading position size using the methodology I discussed in this post.
8) Place your stop at the bottom of the churning area.

Just to clarify what I mean by a churning area, it means an area where to stock price is going sideways for a couple of days or a week at the most.

Let's take a look at some sample trades:

After confirming that BIDU is in a range/consolidation, therefore calling for a range trading strategy, the stock retraces to the $320 level. You see the small churning area (blue circles), and at the same time,it is near the moving averages as support. Also, we see the oversold readings for the stochastics (red circles). Drawing your lines (green lines), you identify that the area pattern is a rectangle. You buy the stock on the break of the two churning areas which are $330 and $328 respectively (two red arrows), placing your stop below the churning area. The target is the resistance level of $353, or about a 7% to 8% upside for each of the two trades.

Here we have another example in SHLD.

Once again, we confirm that SHLD is entering into a range/consolidation with the MACD crossdown and nearing zero. It corrects to near the 32-day moving average, and forms a churning area (blue circle) at between $61.40 to $64.40. The slow stochastics reading is also below 20 (red circle). You buy the stock on the break of $64.40 (red arrow), with the target of $72, with the initial assumption that the area pattern will be a rectangle. Place your stop at the low of the churning area of $61.40. However, the stock stops at $68 and moves down again. You could raise your stop to your purchase price of $64.40 when this happens, or sell when the stock backs off a dollar from the high of the rally. This way at worse you just break even. The fact that it didn't retest the resistance of $72 means that the area is not a rectangle, and could possibly be a falling channel or a triangle. Here we see it breaks the $61.40 support so it is clearly a falling channel. We wait again for the stock to form a churning area and for the stochastics to fall below 20 (red circle). You buy the stock as it breaks $58 and target $66 (upper trendline of the falling channel). In this second trade you gain 14% in seven trading days!