When you see a stock in an apparent range-trading pattern, do you visualise a breakout, a breakdown, or a continuation of range-trading? Any of the three patterns is possible and if you guess right, you could make money from any of these.
The ideal methods of trading these patterns are very different. What you decide depends on your mindset, rather than technical or fundamental analysis. Aggressive traders prefer to optimise trading styles to exploit breakouts. Conservative traders try to exploit range-trading instead.
The most exciting situation is a breakout, or its mirror-image, the breakdown. In effect, these are similar, assuming it is a liquid market, where the trader can short easily. Either a breakout or a breakdown may set up a trend and trends can lead to large profits.
The really aggressive trading styles buy at the top of a trading range anticipating a breakout, or sell at the bottom of the range, anticipating a breakdown. That way, profits are maximised. Of course, if there is no breakout, there may be large losses. Less aggressively, some traders wait until there is an actual breakout. This gives up some potential profits but also limits possible losses.
Breakouts (and breakdowns) are unpredictable. They occur more rarely than continued range-trading. Breakouts can often fail. It is most frustrating if there is a breakout, followed by a correction that re-establishes the previous range-trading pattern.
Even when the breakout sustains and becomes profitable, it is always difficult or outright impossible to establish a price target. Every time there is a correction, the trader will wonder if it’s time to book profits. As and when the trend reverses, a winning position may rapidly go into loss. The trader must keep resetting stop-losses to ensure he keeps some profits if the trend changes, while also ensuring he doesn't book profits too early.
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Conversely, range-trading patterns are predictable, since the price oscillates between defined levels. The trader can buy at the support and sell at the resistance, booking relatively small but relatively sure profits each way. Stop- losses are easy to set.
If there’s a move outside the trading range, the position will be closed out. Conservative traders play range trading patterns and hope there won't be a breakout. If there is, they will book relatively small losses.
Some traders specialise in one sort of pattern and some in the other. This appears to be a question of temperament. In most markets, one can find potential breakout or potential range-trading patterns and pick and choose which ones to chase. Very few traders are equally comfortable handling both patterns.
Assuming proficiency, the returns will vary according to the type of pattern. A trend-follower will usually have more losing trades than winning ones. He will have to set relatively wide stop losses and, thus, lose more on each trade. He will need patience. He must hope the returns from every winning trade are large enough to over-compensate for more frequent losses
A range-trader will have relatively fewer losing trades and will be scoring more winning trades than losing ones, if he’s proficient. He can also afford to set tighter stop losses and hence, will lose less money when wrong. But his gains on each trade will also be relatively low.
If the trader is operating on a low capital base, a range-trading style is more sensible. A couple of big losses chasing failed trends can lead to ruin. Inverting this logic, if you like using your capital to the fullest degree, it’s safer to be a range-trader. Alternatively, if you like trend-following, you should always take smaller positions relative to available capital.
Very few traders seem to think their style through carefully. Over time and with experience, preferences evolve gradually, usually with some painful losses thrown in. A little thought and some deliberate experimentation could help ease the process.
