The Trouble With Ranges

My old friend, Michael, has been watching the rally for signs of exhaustion or continuation with an eye on trading Direxion’s 3x/-3x financial sector ETFs, symbols FAS and FAZ respectively.

Last Friday, he wrote about FAS that it “looks like a classic range rider pattern to me. If so, and if it isn’t over, the next stop is $13.50 followed by a dip to around $10.” He noted that “it could be getting a bit long in the tooth.” Here’s the chart he sent with those comments:

Based on that, Michael went long FAS, enjoyed Monday’s fat 18% gain, and sent me this follow-up:

Today went as predicted by the pattern in the chart. I’m very short term, and could be switching horses as soon as tomorrow, although that would be quick for the pattern to hit a top. I do expect a downturn after the spike we are seeing now, even if the uptrend continues. This rally has been ziggy zaggy all along. With an 18% day today I’m leaning toward a hair trigger…and I have a healthy chunk of change in reserve too.

Catching an 18% day is a fine piece of work for a trader. If we expand the view, however, we can see that a longer term and a proper swing trade results in less trading and more profit per trade. That same FAS, for instance, would have produced a 375% gain from its March 6 low to its May 8 high. That would have been perfect, which nobody ever pulls off, but even cutting away the extreme points on the range leaves a lot of room for big profits.

Which brings us to the trouble with ranges. What did FAS’s trading range tell you down to the March low? Have a look at the early February to early March range:

Connecting the Feb. 9 and 26 peaks with a straight line told you that the top of the downtrend range fell at about $3.73, which FAS hit on March 10. That was when range trading told you to get out, but was precisely when you should have either gotten in or already been in and held tight for the rally ahead.

Which is why I wrote back to Michael:

One thing to keep in mind with ranges is that their most profitable moments happen when they stop working — and unfortunately that profit comes only after you somehow know that what the range has been saying repeatedly no longer applies. In other words, the range is most profitable when it’s finally wrong. At the break out or break down moment, the range will say to sell just when the up move will accelerate or buy just when the plunge gets out of hand.

That doesn’t make trend analysis useless, but does give it the same hazy quality as all other market methods. Personally, I’ve come to find trends best when I disagree with them and think that their end is imminent and that the time for going against the grain has arrived.

To which he replied, “Agreed. There is a truism here: range riding works until it doesn’t. And typically it takes most of the life of a range to have enough data to identify the pattern. Once that pattern is well enough defined to recognize, there is usually only a limited life expectancy before the until it doesn’t phase. I agree with you that we are probably nearing that point on this one.”

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