Most systems in trading are trend-following systems. But the market can be in a tight range over a long period.
What is the sideways market?
A sideways market or a sideways drift occurs when the prices of investments remain in a tight price range for any period. They do not form many distinct trends for a significant time. The price action tends to be horizontal, and it doesn’t move above the previous highest price or fall below the last lowest drop. In such a market, neither the bulls nor the bears take charge of the market.
So, let us see what is trading sideways in practice.
What does trading sideways mean?
Trading sideways represents the trading style when open positions are made within a reasonably stable price range without forming any bullish or bearish trends over some period of time. Usually, trading sideways presents trading in a tight price range.
While sideways trend or drift can occur in any investment like bonds, foreign exchange, and other commodities, it is often seen in the stock market, including the S&P 500, the Dow Jones Industrial Average, and the NASDAQ.
How to identify sideways market
The best way to identify a sideways market is the identification of support and resistance levels. Support and resistance levels create a range where traders enter a position once the price drops to support level and sell when the price rises to resistance levels. Trading sideways implies buying assets at the support level and sell on the resistance level.
But, how we can predict the future range market. I know it is almost impossible but are there any signs that can help us?
How to predict a sideways market?
To predict the sideways market, traders need to identify volatility decrease using indicators (ATR, volatility, VIX, etc.) and defined price range using support and resistance to predict sideways. Usually, price oscillation in the range and a clear declining trend in volatility are early signs of the sideways formation. However, it is tough to create any prediction in financial markets and the sideways market.
For example, AUDCHF the whole summer of 2020. is in the tight range on the image below:
The Information Provided by the Sideways Market
One of the basic things that a sideways market tells a trader is that the price trend will not see a sudden change. It will move horizontally or in the same direction as before. A sideways market is not the calm before the storm. A sideways market doesn’t occur before an immediate significant change or shift in the market.
Since the stocks are neither reversing nor reaching a larger price, this situation is also called consolidation. During this period, the traders are unsure how the market would react once this stable period is over. They build on their past gains with caution, waiting for the market to reverse its course. As time progresses without any change and the traders keep holding on, they gain confidence. Consolidation often happens when the market is about to go higher or lower than the previous highs and lows. The only exception is if it is occurring during the transition of a business cycle. It then foretells the upcoming phase of the business cycle.
For example, during the business cycle’s peak, there might be a period of irrational movements. A sideways market may also occur before the market is preparing to become bearish. Similarly, a recession, which often marks the bottom of a business cycle, can make a sideways market signal that the bulls control. Economic indicators can guide you during this time. They show the current phase of the business cycle.
How to Predict a Sideways Market?
Algorithms based on machine learning and simple regression models usually can not easily predict the sideways market. However, low volatility, low impact trading news usually follow range markets. The market can be in a tight range for a few hours but several months as well.
A sideways market depends on two things, support and resistance. In a trading market, the buyers come back in when support is the price. They don’t let the prices fall below their comeback price. Au contraire, the buyers sell their investments where there is resistance as they are certain they will go any higher. One can easily predict whether they are dealing in a sideways market or not by assessing support and resistance levels.
A sideways market is more neutral in the sense that it operates within support and resistance. This situation is referred to as a range-bound market. There may be occasional highs or lows, but the price movement neither crosses the highest high nor dips below the lowest low. In case it happens, that is the end of the sideways market. It, then, makes way for either a bull market or a bear market. The bulls take over when the prices exceed the resistance levels, and the bears take over when the prices fall below the support level.
How to Leverage the Sideways Market?
Since the price movement is horizontal in a sideways market, it offers fewer trading opportunities to the day traders. It is a slow market and better suited for the ones who are planning to buy and hold. No trading market stays stable forever; the sideways market will change as well. Before it happens, days traders are advised to diversify their investments. In this way, they might not gain too much, but they won’t lose too much either.
Smart asset allocation is the key to leveraging a sideways market. Here, time becomes secondary. Day traders need to rebalance their allocation in a sideways market.
For example, in January 2018, there was a beginning of a sideways trading pattern. On January 26, 2018, the Dow reached 26,616.71, which was a record closing high. However, it ended up in correction territory and has been trading in a sideways range between 23,00 and 25,700 since then.
Another incident of a sideways market occurred when the contraction phase of the business cycle ended in 2011. The gold hit $1,895 an ounce. The fear of further contraction pushed investors to boost their prices. They wanted to avoid the Congressional threats of a potential debt default and a debt ceiling crisis. The commotion cost various traders a massive chunk of their investments when the bull market in gold ended, and the gold market traded sideways for most of 2012. The gold market often becomes bullish during crises. In 2013, the gold prices entered a bear market because the economy was improving. The prices kept on falling in 2014.
In the middle of an expansion phase of the business cycle, the traders may switch from small-cap stocks to large-cap stocks. Here, consolidation occurs, which can also signify a sideways trend.