As many of you who read my posts regularly know, I love trading narrow range setups. The primary reason for this is that I can greatly reduce my risk by stopping out as close to my entry as possible. This allows me to increase my risk versus reward as a multiple. In other words, if you are trying to limit yourself to trading opportunities with a minimum of 3:1 risk versus reward, it is much easier to shoot for a $1.50 gain while only risking $.50, than it is to shoot for a $15 gain while risking $5. While keeping your risk tight may expose you to more whipsaws, by waiting patiently for these narrow range setups to develop and then pouncing as the range is cleared, a trader can keep their win rate at acceptable levels.
Another important note is that a narrow range setup is not a trading system. It is a trading technique that can be applied to any setup or system. Traders can adjust this technique to their system by applying it to intraday time frames, or by using it as an entry technique for their own trading methodology. Not all stocks will provide a perfect entry with minimal risk, but traders should always be looking to be as efficient as possible in setting their risk.
The following setup is one example of how I trade using a narrow range to base my trading decision from. American Capital Ltd.(Public, NASDAQ:ACAS) had more than doubled in price between January, 2010 through May, 2010 before settling into a consolidation. This type of rally typically needs some time to absorb profit taking, and ACAS has been building a base since its May peak. Notice how the trading range was wide and volatile in the beginning of the base and has slowly narrowed in range as buyers and sellers reach an equilibrium. This is healthy behavior as shares exchange hands among market participants. The first positive step in this pattern is when ACAS cleared a descending trendline in September while also setting its first higher pivot high in months. It had also started to set progressively higher lows since June showing that buyers were slowly increasing their bids.
While the breakout from the triangle it had formed was a possible trading signal, the risk versus reward was not that attractive after a 3 or 4 day rise. However, ACAS has since settled into a very tight range while maintaining above its August high. The current trading range is only about 35 cents wide, which would leave a trader with a very small risk on a break above this range, assuming a stop out on a move back below the range. A trader could possibly tighten the stop even more, using the bottom of the candle used for the trades entry. So assuming an entry near $6.00, the most conservative target would be taking profits near the prior high near $6.65. While this works out to roughly 2:1, this setup actually has the potential for a much bigger gain. The measured target for the triangle breakout is closer to around $8.00. While I would likely be more conservative an eye the January 2009 peak just above $7, the potential for a surge does exist.
So this setup is attractive to me based on the fact that ACAS is starting to emerge from a base and has exhibited signs of accumulation. The narrow range that has formed as it consolidates is simply offering me a possible low risk entry for the thesis that ACAS will breakout from the overall pattern. While it would be tempting to cheat and buy before ACAS picks a direction, it is usually a better idea to wait for it to move out of the range. While sometimes you won't get stopped out, these stocks will often remain in a tight range much longer than you wish to wait.
While this trade is not fool proof, it is a trade I would take based on the small amount of risk involved. Traders should always keep an eye on how much they are risking first, and then the possible reward. If the setup fails, it's fine because the risk was limited and will be made up by the gains on the successful trades. If the markets cooperate, then ACAS may soon emerge from this tight range and possibly offer a trading opportunity.
Good Trading,
Joey
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