Trading Channels

In the last two installments of Technically Speaking, we covered support and resistance lines and trendlines. This time around, we will discuss trading channels, which bring together the elements of trends and support and resistance.

A trading channel—or trending channel, as it is sometimes called—is defined as the area between two approximately parallel trendlines, and it is typically taken as a measure of a trading range. The upper trendline connects price peaks and the lower trendline connects lows. Channels are a popular tool of short- and intermediate-term traders, not long-term traders or investors.

According to “Technical Analysis of Stock Trends,” by Robert D. Edwards and John Magee (AMACOM, 2007), well-defined trading or trend channels appear most often in actively traded stocks with a large number of shares outstanding.

Channels can appear over a variety of time periods. Channel trading, which is popular among short-term traders, follows channels that develop through the course of a single trading day. However, you can also find channels that develop over longer periods, perhaps as long as months or even years.

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Creating a Channel

The first step to creating a channel is to locate a past relative high and relative low from which to begin the channel. Once you have done this, the two types of channels you can create are a descending channel and ascending channel.

Ascending Channels

A channel that is moving upward is referred to as an ascending channel, where the trendlines connect higher highs and higher lows. In Figure 1, we see that Apple, Inc. AAPL has been in a general uptrend since early March 2009. The green line represents the main trendline, which we drew by connecting subsequent higher lows. A nearly parallel line is drawn above it connecting subsequent higher highs. With ascending channels such as this, the upper trendline of the channel is also called the “return line,” since it marks the point of return moves against the prevailing trend.

Note that in mid-October 2009 AAPL broke out above the return line for a few days, only to fall back into the trading channel. However, the main trendline held a week later as well as the following month.

Rising or ascending channels indicate short-term bullish rallies in a downtrend or a continuation of an existing uptrend. No matter what type of trading channel you draw, the more times prices test the trendlines and stay within the channel, the more reliable the channel.

Descending Channels

A downward moving channel is called a descending channel. The mechanics of a descending channel are basically the opposite of an ascending channel. In this case, the original or main trendline joins lower lows, and a nearly parallel return line connects the lower highs of the channel.

In Figure 2, we see that Texas Instruments TXN traded within a channel between June 2007 and May 2008, at which point TXN breached the return line, signaling a potential reversal of the downward trend.

The descending channel can indicate a continuation of an existing downtrend, or it can mark a short-term bearish formation if it appears in an uptrend.

Trading With Channels

As mentioned earlier, channels are a trading tool for short-term and intermediate-term traders. Channels can show traders when to buy and sell as well as where to place stop-loss and profit points. They can also help determine how reliable a trade may be and how long you should expect the trade to take. Keep in mind, however, that these are all estimates: There is no guarantee that prices will always behave in the manner in which we expect!

Identifying Buy and Sell Points

When using trading channels to spot optimal buy and sell points, there are some standard rules that apply to both ascending and descending channels:

• Buy long and/or cover short positions when the price hits the bottom of the channel;
• Hold your positions when the price is in the middle of the channel; and
• Sell your existing long positions and/or go short when the price hits the top of the channel.

However, there are also exceptions to these rules:

• If the price breaks through either the upper or lower trendlines of the channel, the channel play ends until a new channel is established; and
• If the price drifts within the channel without hitting either the upper or lower trendlines, a new narrower channel may need to be established.

As with most other types of technical analysis, using channels in conjunction with other technical indicators is a good way to verify their overall strength.

Determining Stop-Loss and Profit Levels

After you have placed a trade based on the price hitting either the top or bottom of the channel, there are some general money management rules for stop-loss and profit-taking points.

• If you bought at the bottom of the channel: Take profits sell at the top of the channel and set a stop-loss point slightly below the bottom of the channel, taking into account typical price volatility.
• If you entered a short position at the top of the channel: Take profits (cover the short position) at the bottom of the channel and set a stop-loss point slightly above the top of the channel, again taking into account typical price volatility.

Determining Trade Reliability

Depending on how “established” a channel is, you have the ability to gauge how likely it is that your trades will be successful. This is dictated by the number of “confirmations” the channel has—the number of times the price has rebounded from either the top or bottom of the channel. The more times the price tests the upper or lower levels of a channel, the more accurate it becomes. At a minimum, look for at least four confirmations before trading a channel. Generally speaking, the most reliable channels are those with at least six confirmations.

Estimating Trade Length

With channels, you can also get an idea of how long it will take a trade to reach a sell point from a buy point. You do this by figuring the average amount of time it has taken for trades to execute in the past. Keep in mind that this is predicated on the notion that price movements within the trading channel tend to be of equal length and price.

Conclusion

Trading channels are a useful tool for short- and intermediate-term traders. By combining two trendlines to define the range in which prices trade over time, you have a tool that helps you determine buy and sell points and establish money management levels.