What is a Trading Channel?
- A trading channel is drawn using parallel trendlines to connect a security's support and resistance levels within which it currently trades.
- Trading channels provide one of the most important overlays that a technical analyst will use for long term analysis and trading decisions.
- Two broad types of trading channels that are popular with technical analysts namely, trend channels and envelope channels.
Understanding Trading Channels
Trading channels are a quite useful in graphically depicting support and resistance levels. Technical traders often rely on them in identifying optimal levels to buy or sell a specified security. Technical analysts can also follow any of a number of patterns that may occur within a channel to discern short term directional changes in market prices. Trading channels, however, provide one of the most important overlays that a technical analyst will use for long-term analysis and trading decisions.
A trading channel is a channel drawn on a security price series chart by graphing two parallel trendlines drawn at resistance and support levels. Generally, traders believe that security prices will remain within a trading channel and will look to buy at channel support and sell at channel resistance. While this type of range trading is nice, the bigger trading opportunity presents itself when there is a channel breakout. When this occurs and is confirmed, then the probability of a quick, significant move in the security's price increases dramatically.
Types of Trading Channels
There are generally two broad types of trading channels that are popular with technical analysts, namely trend channels and envelope channels.
Trend Channels: Trend channels are drawn with defined slope trendlines at the resistance and support levels of a security’s price series. These channels are not used for long-term price analysis since they lack the ability to flow through reversals. Trend channel trading relies heavily on a security’s trend cycle, which spans through breakout gaps, runaway gaps, and exhaustion gaps. Generally trend channels will be either flat, ascending, or descending.
- Flat channel: Flat channels occur when trendlines have a zero slope. These trend channels show sideways movement in the market with no upward or downward trend.
- Ascending channel: An ascending channel is drawn from two positive sloping lines at the resistance and support levels of a price series chart. This channel shows a bullish trend.
- Descending channel: Descending channels are the opposite of ascending channels. These channels are formed from two negative sloping trendlines at the resistance and support levels. A descending channel will show a bearish trend.
Envelope Channels: To take into account longer term price movements, traders can also use envelope channels. Envelope channels have trendlines that are drawn based on statistical levels. Two of the most common envelope channels include Bollinger Bands and Donchian Channels.
- Bollinger Bands: Bollinger Bands are one of the most popular trading channels incorporating moving average trendlines. In a Bollinger Band trading channel, trendlines at the resistance and support levels are based on movement of the moving average. The resistance trendline is two standard deviations above the moving average. The support trendline is two standard deviations below the moving average.
- Donchian Channel: Donchian Channels are a type of envelope trading channel based on high and low prices. The resistance trendline in a Donchian Channel is drawn based on the security’s high over a specified period (n). Adversely, the support line is drawn based on the security’s low over a specified period. Traders can use various periods to create Donchian Channels. Typically resistance and support trendlines will be defaulted to a 20-day period.
Trading Channel Indicators
Traders using trading channels to generate buy and sell orders will typically trade based on the notion that a security’s price is expected to remain within the trading channel. This methodology can require more careful diligence in trend channels, since reversals may occur. In both trend channels and envelope channels, traders typically choose to buy at the support trendline and sell at the resistance trendline.