Channel trading is a powerful yet often overlooked form of trading that capitalizes on the tendencies of markets to trend. It combines several forms of technical analysis to provide traders with precise points from which to buy and sell, put stop-loss and take-profit levels and much more! This article will show you how to create and effectively trade these amazing instruments.
SEE: Technical Analysis
In the context of technical analysis, a channel is defined as the area between two parallel trendlines and is often taken as a measure of a trading range. The upper trendline connects price peaks (highs) or closes, and the lower trendline connects lows or closes. An example of a channel is shown below. Breakout points in channels indicate bullish (on upward trends) or bearish (on downward trends) signals.
Channels are useful for short-to medium-term trading - not long-term trading or investing. The technique often works best on stocks with a medium amount of volatility. Remember, the volatility determines your profit per trade. Channeling also tends to work best when the technique is combined with other forms of technical analysis, at which we take a closer look below.
Finding an Equity
Not all equities can utilize this technique as it requires that the underlying equity has an existing channel in its chart. Generally, a channel consisting of four contact points is necessary for the channel to be considered "tradeable." There are three ways to locate an equity to which this strategy can be applied:
- Manually look through charts to locate channel patterns.
- Utilize software or a service that automatically recognizes channel patterns.
- Subscribe to a company that provides you with a list of equities to which this technique can be applied.
Creating a Channel
Channels are relatively easy to create using these four simple steps:
- Locate a relative high and a relative low in the past from which to begin the channel.
- Locate another subsequent high and low that follows one of the three following patterns (see table below):
a. Ascending channel - higher high and higher low.
b. Descending channel - lower low and lower high.
c. Horizontal channel - horizontal highs and lows.
- Draw two trend lines - one connecting the two highs, and one connecting the two lows. Note that these two lines should be near parallel.
- These two lines form your basic channel after there are at least two contact points with the upper channel and two with the lower channel. More contact points enhance the reliability of the channel.
Trading the Channel
Channels provide a clear, systematic way to trade. In fact, these simple instruments can show you when to buy and sell, where to place your stop-loss and take-profit points, how to determine the reliability of the trade and how long you should expect the trade to take! Let's look at how these can be done.
Locating Buy and Sell Points
Channels help locate optimal buying and selling points. Here are the standard channel trading rules:
- When the price hits the top of the channel, sell your existing position and/or take a short position.
- When the price is in the middle of the channel, hold.
- When the price hits the bottom of the channel, add to your existing position, cover your short and/or buy.
Two exceptions to these rules:
- If the price breaks through the top or bottom of the channel, then the channel play ends until a new channel is established.
- If the price drifts between the channels for a prolonged period of time, a new narrower channel may be established.
There may be times when other forms of technical analysis are needed to enhance the accuracy of the channel plays, and verify the overall strength of the channel. Using other techniques in conjunction with channeling can also help you avoid the side effects of the two exceptions listed above. A few useful ones to keep in mind are:
- Moving average convergence divergence - These can be used to confirm channel movements, especially after a contact is made.
- Stochastics - These are useful to confirm channel movements.
- Volume - Analyzing volume ratios can also help you determine the strengths of different channel movements, which determine the overall channel strength.
- Short-term moving averages - These can provide you with a short-term outlook on a channel play. They are most useful after a contact is made to confirm the change in direction.
- Candlestick patterns - These are useful for spotting channel breakouts.
Determining Stop-Loss and Take-Profit Levels
Channels provide built-in money-management capabilities in the form of stop-loss and take-profit points. Here are the standard rules for determining these points:
- If you have bought at the bottom of the channel, set a (moving) take-profit point at the top of the channel. Also, set a (moving) stop-loss point slightly below the bottom of the channel, allowing room for regular volatility (taking the beta into consideration).
- If you have taken a short position at the top of the channel, set a (moving) take-profit point at the bottom of the channel. Also, set a (moving) stop-loss slightly above the top of the channel, allowing room for regular volatility (taking the beta into consideration).
Determining Trade Reliability
Channels provide the ability to determine how likely your trade is to be successful. This is done through something known as confirmations. Confirmations represent the number of times the price has rebounded from the top or bottom of the channel - in essence confirming the accuracy of the channel. Here are the important confirmation levels to remember:
- 1-2:Weak channel (non-tradeable).
- 3-4: Adequate channel (tradeable).
- 5-6: Strong channel (reliable).
- 6+: Very strong channel (very reliable).
Estimating Trade Length
The amount of time a trade takes to reach a sell point from a buy point can also be calculated using channels. This is done by recording the amount of time it has taken for trades to execute in the past, then averaging the amount of time for the future. This strategy relies on the theory that channel price movements tend to be nearly equal in time and price.
Channels provide one of the most accurate methods from which to trade in any market. By "encasing" an equities price movement into two parallel trend lines, this simple chart can provide the exact points from which to buy and sell, create stop-loss and take-profit points, check channel strength and even estimate how long the trade will take. This technique is a valuable asset to any trader.