Range Trading 101

Let’s face it; you don’t have to be a chart reading genius to know that WTI has been trading in a pretty tight range for the last couple of months. After a year and a half of volatility where moves were marked by strong momentum we have entered a period of short lived, half hearted direction changes. This stasis is not the result of a lack of interest or news, but simply that WTI is caught in a “push me pull you” scenario where the two major trends in fundamental outlook contradict each other. The OPEC production cuts should naturally lead to higher prices but at the same time the increases in output from U.S. producers and a regulatory and political environment that makes that easier are adding to already record inventory levels.

It may seem to some that the situation since December is a bad thing for traders, but in reality for most it is anything but. Those that trade energy futures are rarely looking for a long, sustained move as trading is short term in nature. Given that, trading in a solid, fairly predictable range is much easier than trying to get a handle on huge volatility, providing of course that you know the basics of range trading. While I am sure that some readers of these pages fit that description I am equally certain that there are many that do not. On that basis now seems like a good time to lay out some basic range trading strategies.

1: Identify Your Range: There is, in culinary circles, a famous recipe for jugged hare written by the Victorian English cook Mrs. Beeton that begins “First catch your hare…” The point here is that the first, basic step to range trading, identifying what the range actually is, should not be ignored.

(Click to enlarge)

I should stress first of all that, at least for desk and floor traders, this is not an exact science. On the above chart, for example, the actual range since December 14th is $49.95 to $55.25. The first step is to understand that, given that, $50-55 is good enough. In addition though, it should be noted that we haven’t even got close to the $50 level since the beginning of January. A more realistic trading range can therefore be found by using the $52 level as a base; a level that twice produced significant resistance last year and has provided support multiple times over the last couple of months.

2: Identify Your Trade Levels: Although it may seem counterintuitive, the range that you have identified, even the approximate one, is not where you are going to attempt to trade. Trying to find the exact highs and lows of anything is a fruitless, and pointless, task. For starters, when a range is obvious there are many more people doing the same thing as you which makes trading just in front of the obvious level a must if you want to actually get your order filled.

We are now close to the top of that range, for example, and during Thursday’s spike following the inventory numbers the high in the E-Mini WTI futures contract (QM) was 49.975, exactly one tick below $50. That would have been pretty frustrating for those with orders to sell at $50, but is the kind of thing that happens regularly.

3: Identify Your Strategy: For many people this is step one, but really should be a function of step 2, which in turn is a function of step 1. If the real, tradable range is fairly narrow, say a couple of dollars or so, then playing close to both the top and the bottom makes sense. If it was say $53-55 right now then selling close to the top with a view to buying near the bottom makes sense. Much wider than that, though, and it is better to look for a smaller profit on each trade, at least initially.

My preferred strategy would be to sell say 10 contracts at around $54.80 with a view to buying back around 8 at roughly a dollar lower. That still leaves you with a position to run to the bottom of the range if momentum is maintained, but with a sensible stop loss on the remaining two contracts it guarantees a decent profit. Speaking of stop losses, where you set them for the initial trade is obviously important. Ideally you want to be just outside the real range, so in this case 55.30 would work. Obviously, if we run down to around $52 then it is simply reversed, buying at around 52.20 and selling the majority at around $53.20 with a stop at around 51.75.

Range trading really isn’t that difficult to do, as you can see, but some basic rules of trading do still need to be observed. Stop loss orders should be placed to protect against a breakout from the range, but should also be structured in such a way as to give a favorable risk/reward ratio, and a disciplined approach to taking profits and losses is essential. The most important thing though is to take it one step at a time rather than just jumping in with a vague feeling that we are near the top or the bottom. If you do that then “range bound” becomes a positive state for the market rather than a reason not to trade.