The channel is a chart pattern that is commonly used by active traders. This price pattern is formed during a period of indecision and is recognized by its unique shape. As you can see from the chart below, the pattern is constructed by drawing two parallel trendlines that connect a series of highs and lows. Both trendlines act as barriers, preventing the price from heading higher or lower. Once the price breaches one of these levels, a sharp move usually follows.
Channel patterns are generally deemed to be neutral in direction until the price breaks above or below one of the trendlines. A break above the upper trendline is used to signal a move higher, while a break below the lower trendline signals the beginning of a move lower. The slope of the trendlines can often vary, which creates different types of channels. The most common version is when the trenlines are horizontal and create a sideways trading range, but it is not uncommon to see the trendlines slope upward or downward; if identified correctly, this slope can be used to determine the direction of the primary trend. Let's take a look at a few companies that are trading within a channel formation, or those that have recently broken out of one and could be ready to make a sharp move in the near term.
Honeywell International Inc. (NYSE:HON) - Taking a look at the daily chart of HON, you'll notice that the price has been confined within a horizontal channel since early 2007. The horizontal trendlines have acted as strong levels of support and resistance; this created an interesting opportunity when the price recently fell toward the lower trendline. Range-bound traders will watch for the price to bounce off the $53 support like it has in the past. This group of traders will anticipate a corrective move that will send the price toward the upper trendline ($62). On the other hand, breakout traders will wait until the price moves beyond one of the trendlines and will then try to take a position that benefits from the move that generally follows. For more on this pattern, see Channeling: Charting A Path To Success.
AGCO Corp. (NYSE:AG) - AG is another company that has been trading within a horizontal channel. This chart will be of specific interest to short-term traders because the bears were able to send the price below the lower trendline today, which suggests that the sideways direction is over and that the short-term direction will be downward. Most technical traders will likely watch this stock for a few days to confirm that the breakdown is valid and most will carefully watch for the volume to increase because this would be a clear sign that investors are looking for the exits.
The Chubb Corporation (NYSE:CB) - Taking a look at CB, you'll notice that the price has remained within a sideways channel since 2006. Notice how the stock has been confined between $47 and $56 for the past two years. In this case, the horizontal channel is still forming, so more time will be needed to see which of the levels will be tested first. This chart is a good example of why a trader needs to have a lot of patience - it wouldn't be surprising to see this type of horizontal channel stay on a trader's radar for weeks/months as it develops.
Monster Worldwide, Inc. (Nasdaq:MNST) - MNST is also trading within a channel pattern, but as you can see from the chart, the pattern is sloping downward rather than sideways. This pattern suggests that the bears are in control of the longer-term direction and many wouldn't expect this stock to move higher until it tests the support near the lower trendline. It is important to note that a true reversal of the trend wouldn't be signaled until the price is able to move above the upper trendline. However, as you can see from the chart below, the 200-day moving average, which is a common level of long-term resistance, is also near the trendline. Many traders may want to wait until this level is broken before betting on a trend reversal.
Channel patterns are a staple for many traders because a break beyond one of the trendlines generally suggests that a period of indecision has ended and that a new trend is about to begin. In some cases, a trader will need to have a great deal of patience because this pattern does not form over night. It is not uncommon for a horizontal channel to form over several years, but when a breakout does finally occur, the move that follows can often be very profitable.
For more on channels see:
Track Stock Prices With Trendlines
Trading Trend Or Range?