Last Updated on 3 November, 2022 by Samuelsson
Any financial market can trade upward, downward, or sideways. When the market is trading upward, we say it’s an uptrend, and when it is trading downward, we say it’s a downtrend. But what does trading sideways mean?
A sideways market is a situation where the price fluctuates within a tight range for an extended period of time without trending one way or the other. It is a horizontal price movement that occurs when the forces of supply and demand are nearly equal.
In this post, we’ll discuss the following:
- Sideways market definition: what is a sideways market?
- Basics of sideways market movement
- How to identify a sideways market
- What does a sideways market tell you — good or bad?
- Strategies for trading a sideways market
- The pros and cons of trading a sideways market
Sideways market definition: what is a sideways market?
A sideways market is a situation where the price fluctuates within a tight range for an extended period of time without trending one way or the other. It is a horizontal price movement that occurs when the forces of supply and demand are nearly equal. It often announces a period of consolidation before the price continues a prior trend or reverses into a new trend.
Sideways markets can also be referred to as range-bound markets, ranging markets, non-trending markets, or trendless markets. In that situation, instead of price trending up or down, price simply oscillates in a horizontal range or channel, with neither the bulls nor bears able to gain control. It may represent a period when the institutional investors are either accumulating new positions or distributing their previous positions.
Sometimes, the price move between two established price levels that form support and resistance zones, but there are other times when the price just keeps swinging up and down haphazardly while maintaining a certain average level. In this situation, the sideways markets may be referred to as choppy. It is often a sign of indecision, in anticipation of a financial or political event or an economic decision.
Long-term investors don’t usually like a sideways market, especially when it lasts for a long time, because the price doesn’t significantly move up or down to make them money. However, experienced short-term traders know how to trade the range-bound market and make money. Also, savvy investors know when sideways markets present a good opportunity to enter a trade in readiness for the emergence of a new trend.
While trading a sideways market can be tricky, certain options strategies maximize their payoff in such situations. Some investors profit by selling call and put options with approaching expiration dates, especially if the sideways drift is expected to remain for an extended period.
Basics of sideways market movement
The price normally swings up and down, irrespective of the direction the price is headed. If the price is trending upward, the upswings would be larger than the downswings, and if the price is trending downward, the downswings would be larger than the upswings. However, when the upswings and downswings are relatively the same size, the market does not make any significant upward or downward displacement — it moves sideways!
Sideways markets are typically characterized by regions of price support and resistance within which the price oscillates. That is, the market moves sideways if the price is confined within the boundaries of strong levels of support and resistance. A downswing bounces off a support level and reverses to start an upswing; when the upswing hits the resistance level, it reverses to start a new downswing — more like the tennis bouncing between the floor and the ceiling. In this situation, the market is said to be range-bound.
A sideways market is seen as a period of price consolidation before the continuation of the preceding trend. These periods of consolidation are often needed during prolonged trends, as it is nearly impossible for such large price moves to sustain themselves over the longer term. However, it could also be a period of accumulation or distribution. It is not uncommon to see sideways price action for a prolonged period before the beginning of a new trend uptrend or downtrend. A period of accumulation after a downtrend often heralds the beginning of an uptrend, while a period of distribution after an uptrend heralds the beginning of a new downtrend.
One of the indicators that give away a sideways price movement is the trading volume; it mostly remains flat during a sideways trend because it is equally balanced between bulls and bears. But most importantly, it can tell when a breakout (or breakdown) is expected to occur — it shoots up sharply, indicating increased activity in the market, and the color code would be in agreement with the direction of the breakout/down. Traders also look at other technical indicators and chart patterns to provide an indicator of where the price may be headed and when a breakout or breakdown may be likely to occur.
How to identify a sideways market
To know how to trade a sideways market, or even determine whether to trade it or stay away from the market, you need to be able to identify it first. Here are the things to look out for if you want to identify a sideways market.
The first thing to do is to find out the levels of support and resistance. A support level is the price level where buyers come back in to buy the asset — they don’t let the price fall below that level. A resistance level, on the other hand, is where buyers sell the investment because they don’t believe it will go much higher. It is also the level short sellers place their short orders.
You know these levels from the way the price bounces off from them and reverses. The support level is like the floor, while the resistance level is like the ceiling. When you see that the price is bound within the boundaries set by those two levels, then, the market is moving sideways.
As the price continues to move within those two levels, there may come a time when it would break out of one of the boundaries, but it may not follow through with an even higher high or lower low. So, it may end up extending the support or resistance level and turn them into zones.
Eventually, the price would break out and follows that up with an even higher high or lower low, bring an end to the sideways market and marking the beginning of a new bull or bear market. However, there can be many false breakouts before a genuine one eventually occurs.
What does a sideways market tell you — is it good or bad?
Is a sideways market good or bad? What does it tell you about the market condition and how to approach it?
Well, as with every phase in the market, a sideways market is neither good nor bad; it all depends on how you approach it. A sideways market is just another phase in the market, which you can either trade if you have a strategy that is suited for that market condition or stay away from the market until the market condition that suits your strategy emerges.
But basically, a sideways market tells you that the market is taking a break (consolidation), as it is characterized by reduced trading activity and low trading volume. Consolidation is a normal part of trading action and often occurs after some reasonable trend in one direction. It shows that traders are uncertain as to which direction the market could make next. So, they are being cautious while building on past gains, as they wait for the market to reverse its course. The longer traders hold on and don’t see any definite change, the more would want to push the price in one direction.
However, what would happen after the break is uncertain. The price can continue to move in the same direction it had been in before the consolidation, or it can also change direction and trend in the opposite direction. But there may be clues to know the likely direction of a breakout.
One clue is to consider the general economic situation to have an idea of the phase of the business cycle. A market consolidation during a transition of the business cycle may signal the next phase of the business cycle and a reversal in market direction. For instance, let’s say a period of extreme price movements and high valuation of assets precedes a period of price consolidation, it could signal the peak of the business cycle or a distributive phase of the market. What may follow next could be a bear market.
Similarly, a recession marks the bottom of the business cycle, so a sideways market during a recession is likely an accumulation phase in the market and could signal a new bull market. So, it’s important to pay attention to the leading economic indicators, as they can tell you the phase of the business cycle; you can then use the information to interpret.
Apart from the economic factors (fundamental analysis), a technical clue to consider is the appearance of false breakouts. After consolidation, the price is more likely to move in the direction opposite to the one it made a false breakout. If there’s a false breakout to the upside, the real breakout could be to the downsides, and vice versa.
Strategies for trading a sideways market
A sideways market is difficult to trade for both short-term traders and long-term investors. However, a long-term buy-and-hold investor may not bother, provided he considers the asset fundamentally sound and a good investment. He would simply buy and hold and wait patiently until the market rises and makes him money. However, there is still the danger that the period may be a wrong phase of the business cycle, and a bear market emerges. With that in mind, let’s see how long-term investors and short-term traders can trade a sideways market:
For buy-and-hold investors, trying to time the market is not important. What matters to them is to have the right asset allocation. So, when the market is moving sideways, it’s time to rebalance the portfolio and ensure that it is diversified. That way, the investor reduces risks while waiting for the market to start moving up again.
Short-term traders base their trading decisions on technical analysis. With technical analysis, there are two ways to trade a sideways market: trading the breakout and trading the up and down price swings if the range is big enough to make some money.
Trading the breakout
Trend-followers and momentum traders like to trade breakouts. They would wait for the price to either close above the upper boundary to go long or close below the lower boundary to go short. Some of the techniques they use to know the validity of a breakout are micro-consolidations around the boundary before the breakout and a false breakout in the opposite direction.
Trading the price swings within the range
If the range of the sideways price movement is large enough, some short-term traders would trade the price swings from the boundaries of the range. They try to go long from the lower boundary (support level) and exit just before the upper boundary (resistance level). When possible, they try to short from the upper boundary and exit before the lower boundary.
The pros and cons of trading a sideways market
There are many pros and cons of trading a sideways market.
These are some of the pros:
Clear entry and exit levels: there are usually clearly defined support and resistance levels, so a trader knows where to look for trade setups. A hammer candlestick pattern at the support level can be a good signal to go long and set a profit target before the resistance.
Tight risk control: When trading a sideways market, traders are super cautious. They set a stop-loss order to minimize the trade’s downside.
Incurring more transaction costs through frequent trading: This type of trading usually presents more trading opportunities than trading a trend. With more frequent trading comes more trading costs in spreads and commissions.
Having to spend more time in front of the screen: Trading more frequently means spending more time in front of the screen to analyze the markets, place trades, and monitor them.