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Range Bound or Trending?

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Earlier this year, a Traders Corner article discussed favorite indicators and how those might change as the market switched from range bound to trending and back again. When markets trend, oscillators such as stochastics become less useful and moving averages become more important. If markets trend higher, for example, a stochastics sell signal might hint at a pullback but produce only sideways consolidation. Taking such countertrend signals can deplete trading accounts, so it's important to recognize when a market might transition into a trending mode or out of it. This article discusses several ways in which a range-bound or trending market might be identified.

One easy axiom alerts day traders to a possible change in tenor. That axiom states that small-range days tend to follow large-range days, at least on the major indices. Obviously, that axiom does not always hold true. Nevertheless, day traders might watch for the possibility of a range-bound day after a day that trended strongly higher or lower. Thursday's doji day on many indices was an example of this axiom holding true.

Other tactics are not always so easy to identify or express, but the next one proves almost that easy. The same observations that help traders identify new entries in a trending market can also pinpoint moments when the market transitions from trending to range-bound or vice versa.

Many technicians use a key moving average to identify buy or sell signals in a trending market. If that moving average slopes higher or lower and prices bounce up or down from it, prices trend, too. A 100-ema often prompts such bounces, with experimentation needed to find the appropriate time frame to watch. If markets trend higher, buy signals that come in conjunction with tests of an appropriate moving average might be taken, but sell signals ignored. If a market trends lower, sell signals might be taken if they come in conjunction with tests of the underside of appropriate averages, but buy signals ignored. The week of May 23-27 provided many examples of trending markets. The SOX was one.

Annotated 10-Minute Chart of the SOX:

The simple observation that a market bounces up or down from a sloping MA identifies a trending market as well as helps to identify new entries. In addition, the market might be transitioning from a trending one to a consolidating one if prices stop bouncing from the key moving average. Although prices sometimes transition directly from trending one direction to trending another, those V- or inverse V-shaped reversals probably don't happen as often as the transition from trending to consolidation.

The SOX provides a couple of examples of such a possible change in trend in the making. Since January 2004, the SOX has been repeatedly testing its 200-week simple moving average from below. With only one-week exceptions, one in January 2005, the SOX has not produced weekly closes above that moving average all that time, until last week. In fact, the SOX has not traded consistently above that average since August 2001. This week will mark a first time that the SOX closed above that average for two weeks in a row in that time. Some might note that this week's candle, a doji-like candle, doesn't yet inspire great confidence in the breakout, so that MA might continue to be watched carefully.

If there had been a little more confidence in the breakout, the second weekly close above the 200-week sma would be the simplest of signs that the SOX's long-term trend lower might be ending. Some choppiness--as visible on a weekly or monthly basis--might ensue as the SOX transitions from that long-term trending behavior below the 200-week sma into consolidation or a new uptrend. In fact, this week's doji-like candle was representative of just such choppiness.

Of course, different time frames provide different viewpoints. From May 11, the SOX has been bouncing from tests of the 15-minute 100/130-ema's. When that stops happening, something that has not yet occurred, although the SOX was testing those averages at the close Friday, the SOX might be transitioning out of its shorter-term trending-higher behavior. If the SOX starts crashing through those averages Monday morning, the short-term ascending trend might be changing and those who had been managing SOX-related trades using methods appropriate to a trending market might step back, watching for a while, prepared to switch gears if the SOX were to consolidate or employ trending techniques again if it instead were to trend lower.

In both instances, a longer-term trending-lower behavior with respect to the 200-week sma and shorter-term trending-higher behavior with respect to the 15-minute 100/130-ema's, a change in behavior near those key averages will help identify a transitioning from trending behavior to consolidating behavior. The same trading vehicle that works best for trade entries in a trending market helps identify a transition from trending to range-bound behaviors or vice versa.

Not all traders watch nested Keltner channels, but those who do are also given clues that markets will be range-bound for a time. This often occurs when those channels line up inside each other, with their basis lines in close proximity to each other. The OEX showed this type of behavior on its 15-minute chart Thursday, ahead of Friday's economic numbers, for example, but the Nasdaq also shows an example on a daily chart.

Annotated Daily Chart of the Nasdaq:

When nested Keltner channels settle into such an equilibrium position, prices might be range bound or move in a choppy fashion. Oscillators such as stochastics sometimes prove helpful in such markets, but they unfortunately sometimes flatten, too, when such equilibrium positions occur. Equilibrium on nested Keltner channels suggests that profits need to be taken quickly, at channel boundaries, if trades are entered at all. Such times of equilibrum often prove to be a time of transition between one trending movement and another.

The presence of consolidation patterns such as rectangular patterns, "p" accumulation patterns or "b" distribution patterns also signal range-bound trading. A last--and, for some, more clear-cut--indication of whether markets are range-bound or trending is the average directional index or ADX. Charting services construct the ADX by combining two values measuring buying strength and selling strength and smoothing the data by taking a moving average. Developed by J. Welles Wilder, this indicator oscillates between 0 and 100, measuring the strength of a trend. Some want to see an ADX level above 20 or 25 before they consider a market trending; others want to see higher values, perhaps as high as 35 or 40. One source uses transitions from below 20 to above 20 as a sign that a trend has begun and transitions from above 40 to below as a sign that a trend's strength may be waning and range-bound trading might begin. Values indicating a strong trend may vary according to the security being watched, so get to know the values that indicate a strong trend in the security you want to trade.

Whatever benchmark you decide works best for the security you trade, watch for times when the ADX transitions from values below that level to values above it as a sign that a trend is strengthening.

Annotated Daily Chart of GOOG:

The ADX line does not indicate whether the trend is an ascending one or descending one, but only whether it's strong or weak and whether it's growing stronger or weaker. Divergences can be useful to watch, too. However, the ADX possesses two other components that do help to assess whether selling or buying pressure strengthens or weakens. That's the selling and buying pressure lines mentioned earlier. Some refer to these positive and negative directional indicators as the +DI (positive) and -DI (negative) indicators. ADX is always the bold line, but different charting services color these other lines differently. As should be obvious from GOOG's chart, QCharts colors the buying pressure or +DI line orange and the selling pressure or -DI line blue.

As with the ADX line itself, these lines can be watched for signs of divergence. A rising trend with bearish divergences showing up in the price/+DI line might offer a warning of waning strength in the trend. Some also suggest using crossings of the +DI and -DI line as buy and sell signals, but as GOOG's chart demonstrates, these crosses could soon whipsaw traders out of their accounts when markets are range bound.

As with all other indicators, ADX requires some time spent becoming familiar with the way this indicator works on the securities a trader most often watches. How can this time be found? By not trading when markets are choppy and range bound, as several techniques described in this article indicated might be true Thursday. Instead, spend those days paper-trading and investigating this tool and others. Avoid giving your money over to your broker as you're repeatedly whipsawed out of trades.

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