In common parlance, markets are generally described using animal spirits, namely ‘bull’ and ‘bear’, but such adjectives are only reserved for trending markets. Trending markets are those whose prices display an upward or downward trend. Stocks in any asset class is likely to exhibit trending behavior of some kind at some point in their life cycle. However, there exist markets where prices remain relatively stable. Such markets are known as ‘sideways markets’.
The defining characteristic of a sideways market is horizontal price movement, wherein price fluctuations occur within a relatively narrow range for an extended period of time. This gives such markets some semblance of certainty and stability. Trading in a sideways market is a different game altogether as it comes with its own set of idiosyncrasies that might not appeal to all traders.
To be able to trade effectively in a sideways market, one needs to know the characteristics of such a market and learn how to use them to one’s advantage. Here are a few salient features of a sideways market:
- Defined range: Sideways markets operate within a narrow range with clearly defined upper levels (known as resistance) and lower levels (known as support).
- Lesser Gains: Because of the relatively small differential between the resistance and support prices, traders who trade in such markets can expect to make narrow margins.
- More opportunities: The predictability offered by a sideways market creates more trading opportunities when compared to a trending market.
- Transient by design: Executing successful trades in a sideways market requires traders to have clearly defined entries, exits and stop-losses. Requires close monitoring to execute effectively.
Learn the Basics
Now that we have a fair idea of what a sideways market is and the kind of features that distinguish it from a trending market, let us look at some of the key concepts to keep in mind when learning how to trade in a sideways market.
- Identify a sideways market: The first thing to do while trading in a sideways market is to be able to spot if it is indeed a sideways market or not. By definition, sideways markets are those where the prices experience periodic bursts of upward and downward movement. This is largely a result of the market’s indecision over the dynamics of a certain market.
A sideways market is easy to spot after it has formed, but the real challenge lies in spotting one as it consolidates. One trait to look out for is a series short spikes within a tight range and could be early indicators of an upcoming sideways market.
- Plot the range: After having identified a sideways phase, it’s important to carve out the upper and lower ranges by examining the ever-changing support and resistance levels. You could also look at trend lines to get a better idea of how to define your range.
- Ascertain internal levels: To reduce uncertainties to a minimum, it is prudent to identify every possible level of resistance and support that could cause the price to hold, not just the more obvious ones. It is particularly important to mark the middle range of a consolidation phase, so as to foresee instances when the prices start to pivot.
- Spikes: One way to succeed in sideways markets is by anticipating breakouts, in either direction. For traders who might be too used to ‘riding the wave’ in trending markets, it is very likely to miss out on calling for quick exits if and when the prices start to dwindle far below the defined range. It is best to adopt a somewhat safe/conservative trading style to guard against such scenarios.
On top of exercising the basic level of cautions, there are other ways to tackle a sideways market. Carefully curated options trading strategies are par for the course when it comes to safeguarding gains, and even increasing their chances of growing. Here a few to consider:
- Short Straddle/Short strangle: These are two very similar strategies that can be used for assets that aren’t expected to move significantly over the tenure of their options contracts.
- The short straddle is a strategy which involves selling both the call and put options that have the same strike price and expiration date. In such a scenario, the maximum profit is limited to the premium collected from writing the options. Losses can be unlimited, so it is typically a strategy for more advanced traders.
- The short strangle is almost the same as the short strangle save for the difference in using out-of-the-money (OTM) strikes of both the call and out options. This strategy is infamous for traders on a tight budget as it saves both time and money.
- Ratio spreads: A neutral options strategy where the trades are structured such that the number of short and long positions has a specific ratio.
- Ratio Bull Call spread: A variant of a vertical spread, this is designed to work best when you expect a moderate rise in the price of an asset. It involves buying an at-the-money (ATM) call option while selling two OTM call options. Doing so allows for a reduced upfront payment and puts the risk-reward ratio in your favour.
- Ratio bear put spread: A different take on the bull spread, it involves buying an ATM put option and selling two OTM put options. Best for instances when the stock is trading at higher levels and a correction is expected.
It is important to note that all the aforementioned strategies work only when the sideways phase is under play. If the market seems choppy or if you are unsure, it is best to sit it out and preserve your trading capital. A choppy market is never worth trading as it increases the chances of over-trading and losing money in the process.