Guidelines for Successful Channel Trading

Ascending channels create the opportunity for investors to take a long position while descending channels provide the opportunity to take a short position. Stop and limit levels are easily defined based on previous support and resistance levels.

Any type of security can be used (equities, bonds, futures and options, foreign exchange (forex) market, etc.). However, channel trading requires choosing a security with an increased level of volatility. This is necessary to create the price movement that is needed to generate profits. Because of the volatility present within the securities being traded, it is considered to have more risk than other forms of trading.

Channels may be present over an hour (this is what a day trader may look for) or over several months. Sometimes a chart may show multiple channels. This increases the opportunity for traders to find profitable trades based on price movement.

Introduction

One of the keys to successful trading is to know the momentum and the trend of a security and then trading in a way to capitalize on the natural fluctuations of the market. No investment, whether it’s an equity stock, bond, currency, or futures contract moves in one direction. Many investors have developed entire trading systems designed on attempting to time the market.

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One way that traders will try to time the market is by finding trendlines and executing trades when these lines meet specific levels of support or resistance. When stocks trade in a specific range, highlighted by defined highs and lows, traders can form a price channel and trade within the range of prices within the channel.

Channel trading is a popular variation on strict trendline trading. It allows traders to execute long and short trades with more precision, allowing them to achieve increased profits. In this article, we’ll review what channel trading is and define some of the key terms that are used to explain channel trading. We’ll also review how to identify a price channel for trading and how to execute channel trading for all kinds of channel types. We’ll conclude the article by reviewing two specialty price channels that can be used in channel trading.

Key terms to understand channel trading

• Trendline– a trendline is a solid line which connects the closing price points of a security. The line connects a defined high price point with the next higher or lower high. Likewise, a trendline can connect a defined low point with the next higher or lower low. A trendline is a visual representation of price movement which can be helpful in spotting trends.
• Price Channel– this is the defined range of price movement for a security established by the formation of an upper and lower trendline. Most traders believe that the majority of price movement will take place within this price channel, thus offering the greatest potential for profit.
• Ascending Channel – this is a price channel that has a positive (or ascending) slope marked by higher highs and higher lows. An ascending channel indicates a bullish trend.
• Descending Channel – this is a price channel that has a negative (or descending) slope marked by lower highs and lower lows. A descending channel indicates a bearish trend.
• Flat Channel – this is a price channel that occurs when there is no slope to a trendline. A flat channel indicates sideways movement in the market because there is no clear uptrend or downtrend.
• Envelope Channels – these are variations on price channels that take into account price movement over a longer term, typically based on a moving average. It’s important to note that channel trading is a short-term to medium-term trading strategy so the moving average used should be relatively short (10-day, 20-day, etc.) in order to properly analyze price moves.
• Resistance– the upper trendline denotes a period of ascending prices. When the prices touch that line, they are called points of resistance. Resistance points in trading are similar to why fitness enthusiasts perform resistance training. When resistance is applied to a form of exercise, such as strength training, it tests the limits of muscles. The next goal can only be reached when a resistance level is broken. In the same way with channel trading, the next move up can only occur after there is a clear channel breakout (i.e. when there is price movement that clearly and significantly breaks the resistance line). Once the resistance line is broken, a new channel must be created.
• Support – the lower trendline denotes a period of descending prices. When those prices touch the line, they are called points of support. Like the resistance points, support prices can provide a key trading signal. When prices clearly and significantly break the support line, it generally signals that prices are headed further downward and a new channel must be created.
• Pips– when trading the forex market, a pip is the smallest movement a currency pair can make. Pips are standardized for different currency pairs to help protect investors from large losses which can occur when trading these volatile securities.
• Volatility– this is a measurement of how tightly prices of a security deviate from the mean (or moving average). Volatility is important in channel trading because it means there is greater price movement which in addition to increasing risk also increases the opportunity for a reward.

How to identify a price channel

1. Determine a high and/or a low from the past to use as a starting point. Day traders and other professional traders may choose a point that is within the same day, particularly if they are trading more volatile securities.
2. Find the next high and/or low. There is no limit to the number of points you can use, but a price channel must have a minimum of four points (two highs and two lows).
3. Connect the high and the low by drawing a straight line through them. The upper line is the resistance line and the bottom line is the support line.
4. If the top and bottom lines are roughly parallel to each other, a clear price channel will appear. At times, more than one channel will appear on a stock chart. This provides an investor with multiple trading opportunities.

Guidelines for successful channel trading

The basic idea for channel trading is the same as any investment strategy. Buy when the prices are low and sell when the prices are high. However, channel traders are looking for higher profits that come from buying at, or near, support and resistance levels depending on whether they are executing a long or short trade. In a long trade, investors are buying when prices are close to support levels and selling when they are near resistance levels. In a short trade, investors are selling when prices are close to support levels and buying when they are near resistance levels.

1. Use channel lines to determine when price action is likely to meet resistance or support for greater profits. This may seem obvious, but many investors may get caught up in holding a stock that is continuing to rise, rather than seeing the potential for larger gains that come from trusting the price movement that happens within the price channel.
2. Watch for channel failures – a channel failure occurs when the price of a security does not reach the channel line (support or resistance). In this case, it can mean the security may be ready to breach the trendline in the opposite direction.
3. Watch for channel breakouts – a channel breakout is an indication that the prevailing trend is getting stronger. When this happens, it may be time to create a new set of channel lines to look for new trends.
4. Use the width of the channel to estimate price movement on a breakout – The width of a price channel is defined as the difference between prices between the initial low and initial high. So a $10 wide channel indicates a $10 difference between the initial low and the initial high. This is considered a relatively wide channel and would likely indicate that if the price were to break out from the channel it would move significantly in the prevailing direction.
5. Set exit positions (stop and limit levels) based on previously defined levels of support and resistance.

Specialty price channels used in channel trading

Before leaving this topic, let’s quickly define two specialty price channels that are used by some investors. These channels are not limited to professional investors; most trading software will automatically make the calculations that are needed.

Fibonacci channel– This is a price channel that starts with a channel line that is drawn through the trend’s high and low. The width of the channel is equal to one. Support and resistance levels are drawn based on the key Fibonacci numbers (23.6, 38.2, 50, 61.8, 76.4, and 100 percent). Traders can buy on an uptrend when prices reach Fibonacci support levels and then pulls back. Likewise, they can sell on a downtrend when the price reaches Fibonacci resistance levels and then pull back.  

Keltner channel– this is the type of envelope channel that includes a moving average center line and two boundary bands. The trendlines of a Keltner channel are curved (like a moving average) because it is measuring the average of a security's high, low, and closing price. For some traders, this is seen as a more accurate reflection of price movement.

The last word on channel trading

Channel trading is a common, and straightforward, a trading strategy that uses common technical analysis to give a visual representation of stock price movement by establishing two parallel trendlines one that plots the highs and one that plots the lows. When seen together, the trendlines should establish the price direction of a particular security. An ascending channel is a bullish signal, a descending channel is a bearish signal, and a flat channel is an indicator that prices do not have a clear uptrend or downtrend. The upper and lower channel lines represent resistance (upper) or support (Iower) for price movement providing clear buy and sell signals that allow for easy trade setup.

Channel trading is used for short-term or medium-term investing and can be done for securities of all types (equities, forex trading, bonds, options, and futures, etc.). It is considered to have more risk than long-term investing because it requires securities that have the necessary price volatility.