The channel is a powerful yet often overlooked chart pattern. It combines several forms of technical analysis to provide traders with precise points for entering and exiting trades, as well as controlling risk. Learn how to identify channels, where and when to enter, where to place stop-loss orders, and where to take profits.
In the context of technical analysis, a channel is when the price of an asset is moving between two parallel trendlines. The upper trendline connects the swing highs in price, while the lower trendline connects the swing lows.
If the price breaks out of the channel to the upside, that indicates a further rally in the price. The chart below shows a channel and breakout in Hyatt Hotels Corporation (H) stock. If the price breaks below the bottom of the channel, it indicates that more selling could be on the way.
The technique often works best on stocks with a medium amount of volatility. Volatility determines your profit per trade. Very little volatility and the channel won't be very big, which means small profits. Bigger channels, typically associated with more volatility, mean larger potential profits.
Finding and Drawing Channels
In order to trade a channel, one first needs to be found. A channel consists of at least four contact points. This is because we need at least two lows to connect to each other, and two highs to connect to each other.
There are three primary ways to locate channels:
- Manually look through charts to locate channel patterns, or trade them as you see them.
- Utilize software or a service that automatically recognizes channel patterns. For example, Finviz or Thinkorswim.
- Subscribe to a company that provides you with a list of equities to which this technique can be applied.
There are three types of channels.
- Channels that are angled up are called ascending channels.
- Channels that are angled down are called descending channels. Ascending and descending channels are also called trend channels because the price is moving more dominantly in one direction.
- Channels in which the trendlines are horizontal are called horizontal channels, trading ranges or rectangles.
Buying or Shorting the Channel
- When the price hits the top of the channel, sell your existing long position and/or take a short position.
- When the price is in the middle of the channel, do nothing if you have no trades, or hold onto your current trades.
- When the price hits the bottom of the channel, cover your existing short position and/or take a long position.
There are two exceptions to these rules:
- If the price breaks through the top or bottom of the channel, then the channel is no longer intact. Do not initiate any more channel trades until a new channel develops.
- If the price drifts between the channels for a prolonged period of time, a new narrower channel may be established. At this point, enter or exit near the extremes of the narrower channel.
During a rising channel, focus on buying near the bottom of the channel and exiting near the top. Be wary of shorting since the trend is up. An ascending channel is depicted below in NVIDIA Corporation (NVDA) shares.
During a falling channel, focus on shorting near the top of the channel and exiting near the bottom. Be wary of initiating longs in a falling channel since the trend is down.
There may be times when other forms of technical analysis are needed to enhance the accuracy of the channel trades and verify the overall strength of the channel. Some other tools to use while channel trading include:
- The moving average convergence divergence (MACD) will often be near zero during horizontal channels. The MACD line crossing the signal line can also point out potential long trades near the bottom of a channel or short trades near the top of the channel.
- A stochastic crossover may also signal a buying opportunity near the bottom of the channel or a selling opportunity near the top.
- Volume can also aid in trading channels. Volume is often lower in channels, especially near the middle of the channel. Breakouts are often associated with a high volume. If the volume isn't rising on a breakout, there is a greater likelihood the channel will continue.
- Candlestick patterns are useful for spotting breakouts, as well as turning points within the channel.
Determining Stop-Loss and Take-Profit Levels
Channels provide built-in money-management capabilities in the form of stop-loss and take-profit levels. Here are the basic rules for determining these points:
- If you have bought at the bottom of the channel, exit and take your profits at the top of the channel. Also, set a stop-loss order slightly below the bottom of the channel, allowing room for regular volatility. See the chart above.
- If you have taken a short position at the top of the channel, exit and take profit at the bottom of the channel. Also, set a stop-loss slightly above the top of the channel, allowing room for regular volatility. Here is a descending channel in BCE Inc. (BCE).
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. These are the important confirmation levels to remember:
- 1-2: Weak channel (not tradeable)
- 3-4: Adequate channel (tradeable)
- 5-6: Strong channel (reliable)
- 6+: Very strong channel (more 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 estimate is based on the assumption that price movements are roughly equal in terms of time and price. However, it is only an estimate and may not always be accurate.
The Bottom Line
Channels provide one way to buy and sell when the price is moving between trendlines. By "encasing" an equity's price movement with two parallel lines, it is possible to generate buy and sell signals, as well as stop-loss and target levels. How long the channel has lasted helps determine the channel's strength. The amount of time a price usually takes to move from high to low (or low to high) provides an estimate of how long trades may last.