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. The truth is sideways markets can be a pain. Usually, at the beginning of your trade, things look great, and it appears the trend will be continuing soon, so you load up on new positions. But reality changes quickly as days turn into weeks and weeks turn into months with minimal movement.
There’s an old adage on Wall Street that says, “the trend is your friend.” I’ve learned this the hard way in the early days of my own trading career, often buying stocks that went nowhere. I started looking for trending companies instead, and eventually, I learned all about momentum indicators and identifying trends.
Along the way, however, I discovered trends aren’t required for a trader to make money. What is required is for the stock to move. It turns out this was an important lesson because I soon realized many stocks spend a lot of time moving sideways.
Often, a stock can get stuck in a sideways pattern known as consolidation. Consolidations are patterns that form when a stock is not specifically trending higher or lower, but rather it is trending sideways.
There are two common patterns that appear during this type of market consolidation:
Today, we’re going to focus on channels.
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. The image below is an example of a channel:
Often 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. This can often be confirmed by looking at longer-term simple moving averages, such as 120-day (6 months) or 250-day (1 year) moving averages. If the stock is trending sideways, you must apply the right strategy to make money in the same way that 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.
There are several approaches to trading a channel. Any of them can work, but all of them require that you recognize the stock is trading sideways upfront and handle it as such. Here are three popular ways to trade a channel:
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 straightforward and fairly easy to execute. The most important thing is to:
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 watched the stock move up and down but never breaking out into a new trend. The active trader, however, would repeatedly buy at support and sell at resistance, taking in a nice profit over time.
The key to executing this strategy is to first identify it and then have 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.
Another popular strategy for approaching sideways markets is to sell options. By design, and all else remaining equal, stock options lose value over time. As an option seller, you can take advantage of this “time decay.”
Many longer-term traders who own the stock will sell covered calls when the stock turns sideways. 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 as the related call option–which they are short–is losing value.
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 is about 1-3% per month which does not include any capital gains from the sale of the underlying stock. If you execute this strategy month over month, that can lead to some very good and consistent returns.
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. Many brokers won’t even let you sell a naked call option because of the potentially-unlimited risk. Instead, many traders use a type of options strategy called a 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. The trader can accomplish 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, they are taking on the huge risk that the trade could move higher. 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 they may have to buy the stock to deliver on the trade. This is another excellent strategy for sideways or stagnant markets.
In most cases, though, the stock will simply sell off at resistance and head back down, allowing the trader to capture a premium for little risk.
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 cannot continue to keep the cash register ringing in your account! If you will deploy a strategy better suited for a sideways market, you can continue to create cash flow month after month. Until next time!