How to Trade When the Market is “Stuck”

In this blog we're going to talk about how to trade when the market is stuck.

Every one of us has experienced that dreaded moment when we buy a stock expecting a big bullish run, only to find a few weeks later the stock is still at roughly the same price it was when we purchased it…

Sound familiar?

Sideways markets can be a pain. Usually, at the beginning of a sideways market, things look very rosy. It appears the trend will be continuing soon so you load up on new positions.

But the reality changes quickly as days turn into weeks and weeks turn into months.

I experienced this on my very first trade.

In 1999 I funded my first trading account and decided to go buy my first stock. I just knew this was going to make me millions.

Like most people, I bought a company that I thought to be a good company. It was a company I was familiar with because I used their products. In fact, I loved their products. I figured if I felt that way about this company, other people would as well.

So I bought the stock. I put in my limit order for $4.90/share and immediately got filled with 200 shares.

A week went by. Two weeks. Three weeks. I checked on my little stock every day to see what would happen… nothing.

After nearly 3 months the stock had literally only moved .15. This was in the midst of the 90’s tech bubble so I knew I had messed up when everything else was trending and my little company was stuck going no where fast.

I ended up selling for about $4.85 a share. We’ll call it a break even and a good lesson. That was the day I discovered….

 

The money is in the trend”

 

The trend is your friend… usually

 

There’s an old adage on Wall Street that say “the trend is your friend.” I learned this the hard way back in 1999 when my first stock didn’t do anything. I started looking for trending companies instead and eventually I learned all about technical analysis and identifying trends early. 

Along the way, however, I discovered that trends aren’t required for a trader to make money. What IS required is that the stock moves (trends), or you apply an option strategy that will make money on a stagnant stock.

It turns out this was an important lesson because I soon realized at least 1/3 of the time a stock gets stuck moving sideways.

Now sometimes a stock is literally going nowhere. It’s the same price a few weeks later as it was when you bought it. That is typically going to form what we would call a “line pattern”. 

 

But more often than not, stocks tend to get into sideways patterns known as consolidations.

Consolidations are patterns that form when a stock is not specifically trending higher or lower, but rather it is trending sideways. There are certain patterns that appear during this type of market condition.

Broadly speaking we can identify two categories of consolidation patterns:
  1. Channels
  2. Triangles

 

I’ll deal with triangles in another post. For today I want to talk about channels.

What’s in a channel?

 

A channel is formed when a stock gets stuck trading in a specific trading range. We typically describe it this way:

“A stock, moving sideways, between support & resistance in a predictable repeating pattern”

Here’s an example of a channel:

 

Often times when people see a channel they assume the stock is not trending. The reality is the stock IS trending, it’s just not trending the way you want it to trend.

During a channel, the stock is trending sideways. If the stock is trending sideways you must apply the right strategy to make money, in the same way, you have to apply the right strategy in a bullish trend to make money, and the right strategy in a bearish trend to make money.

So what is that strategy?

There are several approaches to trading a channel. Any of them can work but all of them require the same thing up front - you must recognize the stock is trading sideways and handle it as such.

Here are three popular ways to trade a channel: 

(1) Trade inside the lines

 

One of the simplest ways to trade a channel is to trade “inside” the channel range. This means buying at support and selling at resistance. 


This strategy is very straight forward and fairly easy to execute. The most important thing is to:

  • Identify the channel early
  • Have the discipline to close the trade

With this basic channel strategy, active traders can take small, but consistent profits, typically every 2-4 weeks, while the longer term trader sits frustrated wishing the stock would break out into a new bullish trend.

Take a look at this trade below:

 

Here a long term trader would have thrown their hands up in frustration as they watch the stock move up and down but never breaking out into a new trend. The active trader, however, would buy repeatedly at support and sell at resistance, taking in a nice profit over time.

The key to executing this strategy is identifying it, and also having the discipline to execute it.

To profit, you must buy at support and sell at resistance. Or, short at resistance and cover at support.

In either case, you want to make sure you set your stop to protect your capital. Typically the stop would be set just below your support line in the case of the bullish trade, or just above resistance in the case of a bearish trade. 


(2) Sell a covered call


Another popular strategy for approaching sideways markets is to sell options. By nature, stock options will go down over time.  As an option seller, you can take advantage of this time decay. 

Many longer term traders who own the stock, like to sell covered calls during this type of market.

Since they own the stock already, selling the call option does not add additional risk to the trade. But it does allow the trader to profit while the stock is going sideways and the related call option is losing option premium. 

In the example above, the trader who already owned the stock could choose to sell a call option as the stock hits resistance and starts to turn down. 


The profits on this trade will not be huge, but they will help to lower the dollar cost average and keep profits flowing in while the stock is stagnant.

Generally speaking, with a covered call the income you can expect to receive over a 3-4 week period is about 1-3%. If you executed this strategy month over month that can lead to some very good, and consistent, returns. 

(3) Sell a credit spread

 

Some traders want to sell options in a sideways market but do not own the underlying stock to place a “covered” position. The result of selling options without being covered is a “naked” or uncovered position. 

In most circumstances, the naked position is not a desirable risk for the potential reward to be made. So a strategy many traders gravitate towards is the credit spread.

The credit spread is a strategy that allows a more active trader to benefit from selling options, while not taking on the risk of a naked option. It does this by purchasing a related long option to serve as a hedge, and thereby creating a synthetic covering for the trade.

Take a look at this chart below: 

 

If the trader sells a call option he/she is also taking on the huge risk that the trade could move higher (unlimited risk profile). To limit this risk the trader will buy a call option just 1-2 strike prices higher.

This new long option now gives the trader the right to buy the stock at a predetermined price. In the event the stock breaks the pattern and starts to trend higher, the trader has already locked down the price at which he/she may buy the stock to deliver on the trade.

This is another excellent strategy for sideways or stagnant markets.

Wrap up

 

Sideways markets can be very frustrating. They can be difficult to identify early, and they can drag on and on. But, just because the stock isn’t trending bullish or bearish it does not mean you can not continue to cash profits. If you will deploy a strategy better suited for a sideways market, you can continue to create cash flow month after month.

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