Why do ranges happen?

Stocks trend when investors and traders consider the underlying company to be undervalued or overvalued at the current share price:

•    When the company is undervalued, the shares are bid, driving the price higher with increasing demand.
•    When the company is overvalued, the shares are offered, driving the price lower with increasing supply.

In this manner, the market proves to be self-correcting as company valuations find their most appropriate level.

On the other hand, when a stock is range-bound, it tends to mean that investors and traders consider the company to be properly valued and that they are satisfied with the current share price. The lower boundary of the range represents support, the level at which the stock is approaching being undervalued. Investors enter the market and purchase the stock at that level, preventing it from falling beneath support.

The upper boundary of the range represents resistance, where the stock approaches being overvalued. When the price reaches that level, investors sell the stock rather than hold it, preventing it from breaking above resistance. Traders who purchased the stock as it approached the upper boundary also tend to sell at that level, in preference to taking a loss on the trade.

Ranges on stock charts tend to hold until something fundamental changes, for example:
•    the company’s earnings improve (or decline) dramatically;
•    the industry sector’s regulatory environment is altered; or
•    the company announces a new and exciting product, or is forced to recall an old one.

The change in the company’s fundamentals forces investors to revalue the company and therefore its shares, breaking the range and generally initiating an uptrend or downtrend, until a new and satisfactory valuation is reached.

Understanding the logic behind stock ranges helps traders recognise the difference between a true range formed through consensus, and a pause in trend, such as a flag or pennant.

When last analysed, Rio Tinto PLC (RTP:NYSE) had broken beneath its long-term uptrend and was resting atop a support level at 50.00, as shown on the chart below:

The stock spiked briefly beneath the resistance level in late January and early February, then rose parallel to the bullish trendline and even tested it from beneath, as resistance. RTP touched a high of 62.24 on 5 April, but shortly thereafter the 40% resources profits tax was announced and the mining industry sector was quickly revalued by investors, sending the entire sector and RTP sharply lower.

In this new environment and with the global financial turmoil resurrected in Europe, support at 50.00 did not hold. The stock slammed through, turned and tested the level as resistance, and when it held turned lower yet again. It found support at 40.00, a 33% retracement from the 52-week high.

RTP has entered a new range between 40.00 and 50.00, where traders may expect it to remain and consolidate while investors consider this new valuation level for the sector.

technical analysis by Craig Liles