How To Use Channel Trading Effectively

Price Action Pattern – Channel Trading Strategy

Price action trading setups occur when a pattern is formed by the movement of the price of a security. The security could be anything – equities, bonds, indices, currency, commodities, derivatives, etc.  So that means you can create a channel trading for stocks or develop a Forex channel trading strategy and be successful with both.

A channel is the area between two parallel trendlines – upper trendline (resistance line), and, the lower trend line (support line).

What is a trendline?  It’s a line drawn over pivot highs or under pivot lows to show the prevailing direction of price.

Upper trendline (resistance line) is drawn by connecting price highs, and, the lower trendline (support line) is drawn by connecting price lows.

Price highs and lows refer to the price a security reaches before reversing and heading back in the other direction.

So for the channel example below, the 3 arrows located on the top(by the resistance level) are considered to be price highs. While the 3 arrows on the bottom(by the support level) are considered to be price lows.

Channel Trading

S&P 500 – June 5, 2017

Channel can also be defined as the range in which the price of a security has traded for a specific amount of time.

Channel trading involves trading the range formed by the channel. Channel trading is most effective for short-term trading, as well as, medium-term trading; but not for long-term trading. This is because of level of volatility needed to use channels effectively.

Sometimes people ask what are the best channel stocks out there?  Here is my response that question: Due to the constant changes in every market it is impossible for me to answer this question in a static article.

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How to Construct a Channel?

I sometimes like to call this setup the trend channel trading strategy because it requires you to setup trendlines every time you want to find a channel.

Here are the steps that I use to form my channel:

1- Figure out a high, and, a low in the past. This will be the starting point of the channel.
2- Find another subsequent high, as well as, a subsequent low.
3- Connect the two highs to draw a line (Upper Trend Line). Connect the two lows to draw another line (Lower Trend Line).
4- If the two trend lines so obtained are near parallel, a channel is formed.

Thus, there are at least two contact points at the Upper Trendline, and, at least two contact points at the Lower Trendline.

Note: More contact points increase the effectiveness, and, the reliability of the channel.

Channels can form on all time frames and can last as short as an hour, or last for months on end.

Channel Trading

S&P 500 – June 5, 2017

Remember: Not all securities will provide a channel. For a channel to appear the security must be volatile.

Types of Price Action Channels

Connecting, at least two, highs (to get the Upper Trend Line), and, connecting, at least two, lows (to get the Lower Trend Line) will generate one of the three patterns described below:

1- Ascending Channel:

Ascending channel would normally have higher highs, and, higher lows (as shown below).

trendline

Ascending Channel (WTI CRUDE OIL – Sep 1, 2017 to Sep 4, 2017)

 

2- Descending Channel:

Descending channel would normally have lower highs, and, lower lows (as shown below).

trendline

Descending Channel (S&P 500- Aug 17, 2017)

 

3- Horizontal Channel:

Horizontal channel would normally have horizontal highs, and, horizontal lows (as shown below).
Channel Trading
Horizontal Channel (S&P 500 – June 5, 2017)

How to Use Channel Trading Effectively!

No matter which channel you are trading, you always buy close to the Lower Trend Line – Support Line (or support level), and, wait until the price is close to the Upper Trend Line – Resistance Line (or resistance level) to book profit.

Ascending Channel Trading Example

Let’s consider WTI Crude Oil Futures. The chart below shows the price action of WTI Crude Oil on Sep 1, 2017.

Price channel strategy

The two down arrows provide us with two highs, and, the two up arrows give us two lows. As the line joining the two highs, and, the line joining the two lows are near parallel, we get a channel. It is evident by just looking at the chart that it is an ascending channel, as the price has made higher highs, and, higher lows.

Before initiating any position, we will wait for a while to confirm if the price remains within the channel. In the example below, I choose to wait for 3 candles to bounce off of the support and resistance lines. The region selected by the diamond box in the figure below confirms that the lower trend line is not broken. Hence, we decide to buy to book profit; as shown in the figure below.

Ascending Channel (WTI CRUDE OIL – Sep 1, 2017 to Sep 4, 2017)

Note: We don’t know if, and, when these levels would be broken. Hence, it is a good practice to keep Stop Loss Order in place. The price at the first up arrow should normally be used as stop loss (not a hard and fast rule; though – a bit lower price than the price at the first up arrow can also be used as stop loss).

After taking profit at the resistance level, you can initiate a sell position close to the Upper Trend Line – Resistance Line (or resistance level); of course, with a Stop Loss Order in place.
When the price reaches close to the Lower Trend Line – Support Line (or support level), book profit.

Descending Channel Trading Example

Let’s consider S&P 500. The chart below shows the price action of S&P 500 on Aug 17, 2017.

The two down arrows provide us with two highs, and, the two up arrows give us two lows. As the line joining the two highs, and, the line joining the two lows are near parallel, we get a channel. It is evident by just looking at the chart that it is a descending channel.

Before initiating any position, we will wait for a while to confirm if the price remains within the channel. The action of the price at star mark in the figure below confirms that the price remains well within the lower trend line, and the upper trend line. Hence, we decide to trade. We can sell to book profit; as shown in the figure below.

Descending Channel (S&P 500- Aug 17, 2017)
Note: Don’t forget to place stop loss order. The price at the first down arrow should normally be used as stop loss (not a hard and fast rule; though – a bit higher price than the price at the first down arrow can also be used as stop loss).

Horizontal Channel Trading Example

The chart below shows the price action of S&P 500 on June 5, 2017.

Horizontal Channel (S&P 500 – June 5, 2017)

The two up arrows give us two lows; hence we get the lower trend line. However, the line joining the two down arrows won’t give a line parallel to the lower trend line. As trading is not an exact since, we should draw a line parallel to the lower trend line, and, wait to check if the channel is formed.

Horizontal Channel (S&P 500 – June 5, 2017)

The action of the price at the third down arrow confirms the formation of a horizontal channel; as now the lines are indeed parallel.

After this a sell trade should be initiated to book profit as shown in the figure below.

Horizontal Channel (S&P 500 – June 5, 2017)

Note: Responsible traders always use stop loss order. The price at the first down arrow should normally be used as stop loss (not a hard and fast rule; though – a bit higher price than the price at the first down arrow can also be used as stop loss).

Price Action Channel Break

It seems channel trading is an effective way to make money in the market. However, things get nasty when the price violates any of the two trend lines (or levels) – namely: Upper Trend Line – Resistance Line (or resistance level) or Lower Trend Line – Support Line (or support level).

Descending Channel (S&P 500- Aug 17, 2017)

Hence, we need a way to figure out which level would be broken. There are two ways to figure out which level would be broken; upper trend line – resistance line (or resistance level) or lower trend line – support line (or support level).

1- Use of technical analysis techniques – like stochastics, candlestick patterns, moving average, etc.

2- Track the total number of buyers, and, the total number of sellers when the price of the security reaches the Upper Trend Line, as well as, when the price of the security reaches the Lower Trend Line (this information can be found in your trading terminal – when you check the details of the security; you intended to trade. Total number of buyers, and, total number of sellers change in real time – if you not sure how to get this, ask your broker!)

a- If the lower trend line (support line or support level) must break, the total number of sellers would be more than the total number of buyers. *

b- If the upper trend line (resistance line or resistance level) must break, the total number of buyers would be more than the total number of sellers. *
*Not a strict rule, but it is a good indicator.

Channel Trading

Descending Channel (S&P 500- Aug 17, 2017)

Channel play ends, if the price breaks any of the trend lines. After this either

a- a new channel would be formed, or,

b- the price would move back to the same channel, or,

c- no channel would be formed at all.

Conclusion

Be careful while choosing the highs and the lows to form the channel. Trading price action/channel trading is not an exact science. Slight deviations can be ignored.

If a clear channel is not spotted, don’t trade.  Make sure to use the price action charts from above to reconstruct a similar setup to help eliminate guess work.

Always use stop loss.

I hope you found this article helpful and that you now understand how to trade channels!

Cheers!

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