Range Trading vs Breakout Trading
Effective Options Trading Strategies - but which is right for you?
Last week we traded AMD options but not the way we had initially planned. That’s because the plan was to capture the breakout, whichever direction, and then ride momentum further. However, the best traders know that you must read the charts and abandon all bias and that is what we did. Range trading took over.
There are pros and cons to both strategies, Range Trading and Breakout Trading, and many of the benefits between the two are indeed shared. Are you a breakout trader? Are you a range trader? Why aren’t you both?
If you’re implementing both strategies, meaning you are selecting whichever strategy is best based on the information presented, you’re going to give yourself more opportunities for success. This is how I trade successfully week in and week out. I’m nimble and I react to the information presented every day, every hour, every minute of my trading sessions.
To get a better understanding of each trading strategy we’ll review last week’s trading in AMD call and put options and we’ll take a look at next week’s trade ideas. These are real examples and charts from recent trading in AMD. Ok, let’s take a look at each trading strategy and the benefits for each as well as what to be aware of. Be sure to stick around for a look at next week’s plan.
Range Trading - Trading between the lines
Range trading is exactly as it sounds. A stock establishes a high price and a low price, and then repeatedly trades back and forth between this high and low. It is simple in this respect. Put another way, major levels of support (lower line) and resistance (upper line) are identified and when the candles approach either they tend to reverse and remain within a trading channel, or range. The idea is to trade the reversals at either extreme of the range. Again, it is simple.
This can be applied to really any timeframe: daily, hourly, minutes. Here’s an example using AMD 10-minute candles from last week. Monday established the range that traded all week long. Tuesday you could have traded calls and puts successfully.
Pros of Range Trading
An obvious benefit of Range Trading is it is very effective in a sideways trading market or stock. Also known as consolidation, there may be extended periods of time where a defined range is established and applying this simple strategy can be very effective. If applied correctly, big profits can be compiled with many smaller trades.
Another benefit is the simplicity of the strategy. Once the resistance line above and support level below are established, all a trader needs to do is wait for the reversal, jump in, and ride the momentum to the other end of the channel. This simple approach allows for tighter risk management.
To manage risk, you must identify how much you’re willing to lose in each trade and then hold to that plan. The reason this is simplified with range trading is the levels are firmly established for you. If you’re taking quality entries just after the candles reverse at support/resistance (s/r), your stop loss will be the s/r line. It is that basic of a strategy and it can be executed very effectively.
For example, in the chart above the candles for AMD bounce off of the 56.45 support level. You might have bought calls after this bounce as an excellent range trade. Notice the candles for AMD do drop back down as a sort of retest but do not get back to the support level 56.45. Had they crossed back below the stop loss aligned with the 56.45 stock price would have minimized losses to around 10% or so in the options trade, depending on your actual entry price.
Instead, the candles did reverse and continued to the opposite end of the channel. Here’s a look at the chart for the $57 strike calls. A 75% gain with no sign of selling until the top of the range for the day. Had you been shaken out at the midpoint, it was still a +40% trade and the most risked was about a 10% loss because of the lower level that established the stop loss. This is a 4-to-1 risk/reward assuming the candles only get back to the middle of the range. This is a trade I’ll sign up for every time.
Cons of Range Trading
The biggest perceived drawback for range trading is the notion that you’re unable to make big profits. If you are looking at a single trade, this is true. But how often do you make a single trade, that trade is perfectly successful, and that’s the only trade you make all day? Right, that never happens.
If you consider all of the trading during the day and the probabilities involved you should come to the conclusion that more often than not, the range holds and trading accordingly is more consistently profitable. This should equate to a higher quantity of profitable trades as you’re trading what is likely to happen. So why do people struggle with range trading?
The temptation for big wins is powerful and often is the reason a trading plan is broken and losses pile up. When you’ve been on a nice run and the candles look like they’ll continue beyond the range, it is very tempting to stay in and watch the big gains pile up. But what happens mentally to traders when the trade quickly reverses?
Now continuing with this example, the candles have given back profits but you’re still up 50%. Take profits right? Unfortunately, the tendency for traders at this point is to hold on hoping for a return to the 75% gains or even better, a move to 100% gains were close to being realized so they wait for that. But those gains are not seen again as the candles drop back down towards the bottom of the range. Profits are given back and traders find range trading frustrating.
The good news is, and I always look for the good news, the nature of range trading is you’ll have another shot at the trade again in the near future. The candles will get to the other side of the range, reverse, and present yet another range trade opportunity. Or, they break through and you swith gears to breakout trading.
Breakout Trading - Trading with Momentum
Breakout trading is focused on riding momentum when a stock price moves outside a defined support or resistance level with increased volume. This is also known as breaking out of the previously defined channel, hence the name breakout trading.
The reason breakout trading is so alluring is this is where the massive 100%, 200%, 300% gains are seen and often posted to Twitter drawing the eye and envy of new traders. You can get in on these trades too! But don’t expect them to be the norm.
What you are not shown are the many losses of 80/90/100% that breakout traders often experience as well. It is true, as long as you’re hitting +300% trades you can take the 100% loss trades. The math works out. However, most are not mentally able to take the -100% losses in a trade and maintain the mental focus needed to continue with their trading plan. This is where things break down, chasing trades occurs, and big losses pile up.
Pros of Breakout Trading
The simplicity of breakout trading is definitely an allure. It is not much more complicated than range trading to be honest. You have a key level that you’re trading off of, waiting for the candles to take the right action and stopping out of the trade if they don’t.
In the example above, the candles breakout above the prior established range. This gets the attention of breakout traders but the best don’t jump in just yet. The best traders know to wait for the retest of the prior level. This is where the lowest cost to enter a breakout trade is found.
Why is this the best spot? You are getting additional points of information, which is always a good thing when trading options. The level of prior resistance becomes support, and when you see that confirmed you can take the trade with confidence that probabilities are on your side.
Notice the continued run to the upside. This is the real reason people are drawn to breakout trading. These can be life changing trades if you hit them just right. And if you maintain discipline, you can minimize losses. That is the ultimate trick.
Cons of Breakout Trading
While breakouts are massively profitable when they go your way there is the risk of a head fake, or that a false breakout occurs. False breakouts are common where big moves in a single direction can be considered rare by comparison. Therefore, you have fewer opportunities for these big gains.
Patience is key when trading and the need to constantly cut losses short on fake breakouts can be mentally difficult to manage. Then, right when you’ve cut another trade for a small loss…the breakout happens and you aren’t in it! Now you’re chasing the trade and taking suboptimal entries which increases the likelihood of losing trades. This is what happens more often than traders will admit.
Simply put, trading breakouts means you’re trading the event that occurs less often. Most traders I know like to trade MORE often and therefore are inclined to take more trades that don’t result in a breakout. There is also a real reluctance to sell when the trade is in a losing position because you have a level of support in the channel that has been traded providing a false sense of security. If the breakout doesn’t occur, the losses will just grow if you haven’t closed the position quickly.
Nate’s Conclusion and Next Week’s Trade
If you’re like me you really enjoy trading and want to be able to trade as much as possible. You also want to ensure you’re maximizing gains and minimizing losses. I think the best way to accomplish this is to be open to information and trade what the chart presents. This means being able to switch between range trading and breakout trading as the candles dictate.
For me, this also means trading the range as my primary approach and then adjusting to breakout trades when they present themselves is optimal. And when I take a breakout trade it is only on the retest of the prior level. Never chase a trade that has already broken out and is running hot. This is where big losses show up, have you experienced this? We all have. Avoid FOMO and chasing trades at all costs.
Last week we traded the range for AMD and that will be the plan again this week. The plan last week was to trade a breakout so perhaps this week’s plans will change too but until they do, range trading is the strategy and the range is 56.05 to 58.92.
A breakout could look like the dotted line forecast below. The retest of 56.05 before the further decline is where I would consider $56/$55 strike puts. Otherwise, I’m trading the range buying $56/$57 strike calls as the candles bounce off of $56 and considering $58/$57 puts as the candles reverse near $58.92.
As always, regardless of your strategy the most important part of trading for any trader is staying true to your plan. If you’re spending hours preparing only to abandon your plan, you never had a plan to begin with and wasted a lot of time.
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Trade informed, trade wisely!