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Trade with Price Channel Pattern Strategy
The Price Channel pattern trading strategy is one of the smartest ways to make money trading. The Price channel pattern is one of the most intuitive and easiest chart patterns. This article will teach you how to implement it in your day to day trading operations.
The good news about the Price channel pattern is the majority of financial instruments and markets trade within a price channel of at least 20% – 25% of the time.
In order to understand the psychology of a chart pattern, please start here: Chart Pattern Trading Strategy step-by-step Guide. Our team at Trading Strategy Guides is working hard to put together the most comprehensive guide on different chart pattern strategies.
It doesn’t matter whether you’re a scalper or a day trader. If your preferred time frame is the daily chart for swing trades, the Channel trading strategy will fit all of your needs.
When studying price charts, you’re better off using channels rather than a simple trendline. This is a more powerful and fair way to gauge what the price is doing. This is because you’re looking to determine upwards and downwards price limits that contain the price.
Moving forward, we’re going to discuss what makes a good Price Channel Pattern. We’re going to lay down a few notes about the psychology behind the Price Channel chart pattern.
What is the Price Channel Pattern?
The Price Channel pattern represents two trend lines positioned above (channel resistance) and below (channel support) the price. The price action is contained between these two parallel trendlines.
The separation between the two trendlines needs to be wide enough if you want to trade inside the Price Channel Pattern. If this is the case, you can buy at the channel support level and sell at the channel resistance level.
However, the biggest trading opportunity comes from the Price Channel Breakout.
When the Price Channel Breakout happens, it can produce significant price movement in the direction of the breakout.
We can distinguish two types of Price Channel Patterns:
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- Upward Price Channel
- Downward Price Channel
- Sideways Price Channel
An upward Price channel pattern occurs when the price makes a series of higher highs followed by a series of higher lows. The price should be contained within the support and resistance lines.
When price breaks out either above or below a buy or sell signal is triggered.
An upward Price channel pattern occurs when the price makes a series of lower lows followed by a series of lower highs. Typically the price should be contained inside the lines that connect these highs and lows.
The best trading opportunity comes from the Price Channel breakout.
Since we’re at the trade breakout topic we recommend you learn some of the trade tactics used by professional traders here: Breakout Trading Strategy Used by Professional Traders.
The sideways Price Channel Pattern can be defined by two horizontal lines as opposed to using trendlines.
Basically, when we have a consolidation or ranging zone, where the price bounces on and off between the two lines – support and resistance.
Using a Channel trading strategy means you can easily identify trade ideas for big profits.
The Psychology behind the Price Channel
If you understand the psychology behind the Price Channel breakout you can potentially save many losing trades. The reason why the Price channel breakout can pose a major shift in direction is because many traders trade inside the channel. They place their stop loss above and below the Price Channel pattern.
Then, as more stops gather above and below the Price Channel Pattern, the stops will eventually be targeted by the smart money. This is because they need the liquidity the stops provide.
It’s important to remember that a price channel won’t last forever. The price channel breakout is inevitable.
Now, let’s see how you can effectively trade with the Price Channel Trading Strategy. You will learn how to make profits without using a technical indicator.
Price Channel Trading Strategy – Sell Rules
Recognizing the signs of the Price Channel Breakout in advance gives you the opportunity to make better trading decisions. Our Price Channel Trading Strategy takes advantage of these warning signs. It provides you with a smart way to trade Price Channels.
Moving forward, we present the sell-side rules of the Price Channel trading strategy:
Step#1: Draw a Price Channel if you are able to see at least two Higher Highs and Higher Lows. The Price Channel pattern is drawn by connecting the highs and lows.
During this stage, we’re looking for distinctive price action that can be contained within two parallel lines. These lines will ultimately form the Price Channel Pattern.
If you’re able to spot two consecutive swing highs followed by two consecutive two higher lows you simply connect these points using the Price Channel tool.
The majority of the trading platforms has incorporated into their default trading tools the Price Channel indicator.
Before the Price Channel breakout, we need to make sure our Price Channel trading strategy complies with one more rule, which brings us to Step #2.
Step #2: Wait for a Swing High to fail to reach the top of the Price Channel pattern.
In the case of an ascending or upward Price Channel pattern the first warning signal that the price will fail to trade within the boundaries set by the Price Channel Pattern presents itself when the last swing high point fails to reach the top of the channel.
Only our Price Channel trading strategy makes use of this powerful price reading technique because our team at Trading Strategy Guide has developed the “early signs” of Price Channel breakout.
The fail attempt to test again the top of the Price Channel is a sign of price weakness which is confirmed when the price also fails to bounce off the Price Channel bottom and breaks it instead.
Note* – The more times a swing High fails to reach the top of the Price Channel pattern the better the trade setup
Step #3: Wait for the Price Channel breakout and for breakout confirmation
One of the worst mistakes traders does when trading Price Channel patterns is that they don’t wait for confirmation signal when the breakout happens.
You should always wait for breakout confirmation!
What do we mean by breakout confirmation?
In simple terms, we want the breakout candle to post a close below the Price Channel bottom to confirm the breakout. We also have training on How to use Japanese Candlesticks.
So we don’t just wait for the Price Channel breakout, but instead, we also want to see the breakout candle closing below the Price Channel pattern. This is a very simple way to avoid many of the false breakout signals.
Note* – The breakout candle needs to be a big decisive looking candle, but it’s not mandatory
Now we need to define our entry technique which brings us to the fourth step of the Price Channel trading strategy.
Step #4: Sell right at the Breakout Candle Closing Price
The Price Channel trading strategy uses a very simple trade entry technique.
A sell order is triggered at the breakout candle closing price.
The Price Channel breakout technique provides us with an entry signal that you can be confident in executing the trade.
The next logical thing we need to establish for the Price Channel trading strategy is where to take profits.
Step #5: Take Profit 1 at the 50% Fibonacci Retracement of the previous trend, Take Profit 2 at the starting point of the Price Channel
The Price Channel trading strategy employs multiple entry techniques.
Our first potential take profit zone is the 50% Fibonacci retracement of the previous trend.
What do we mean by the previous trend?
The trend that was contained within the Price Channel pattern. So plot the Fibonacci retracement indicator between the high and the low of the price channel.
The second potential take profit zone is the Price channel starting point (see in the above figure).
The next important thing we need to establish is where to place your protective stop loss.
Step #6: Place the protective stop loss above the swing high prior to the Price Channel breakout
We’re adopting a very conservative approach when it comes to the stop loss technique. Simply hide the stop loss above the swing high prior to the Price Channel breakout.
We also recommend you to trail your stop loss above the last swing high once you cash in on the first portion of the trade.
*Note: The chart above is an example of a SELL trade… Use the same rules – but in reverse – for a BUY trade, but this time we’re going to use the downward Price Channel. In the figure below, you can see an actual BUY trade example, using the Price Channel trading strategy.
You can use the Price Channel pattern to profit in any kind of market. The trading techniques highlighted in this Price Channel trading strategy can also be incorporated into your current strategy as it will bring a new dimension to your understanding of price action.
The early signs that a Price Channel breakout is about to happen is when the price falls to reach multiple times one end of the Price Channel pattern. This is a warning to the potential ending of the Price Channel pattern.
If you have good trading skills and you’re able to spot the Price Channel pattern earlier, it will give you the opportunity to take advantage of the price bounce between the support and resistance lines.
Read our previous price chart pattern here: Bump and Run Chart Pattern.
Thank you for reading!
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What Is a Price Channel?
A price channel occurs when a security’s price oscillates between two parallel lines, whether they be horizontal, ascending, or descending. It is often used by traders, who practice the art of technical analysis, to gauge the momentum and direction of a security’s price action.
- A price channel occurs when a security’s price oscillates between two parallel lines, whether they be horizontal, ascending, or descending.
- Price channels are quite useful in identifying breakouts, which is when a security’s price breaches either the upper or lower channel trendline.
- Traders can sell when price approaches the price channel’s upper trendline and buy when it tests the lower trendline.
Understanding a Price Channel
A price channel forms when a security’s price is buffeted by the forces of supply and demand, and can be upward, downward, or sideways trending. These forces affect the price of a security and can cause it to create a prolonged price channel. The dominance of one force determines the price channel’s trending direction. Price channels can occur over various time frames. They can be created by all types of instruments and securities, including futures, stocks, mutual funds, exchange-traded funds (ETFs), and more.
Traders, especially those who are disciples of technical analysis, are always on the lookout for chart patterns that can aid them in their trading decisions. Once a security’s price action carves out a set of highs and lows that follow a discernible pattern and can be connected by two parallel lines, a price channel has been formed.
The lower trendline is drawn when the price pivots higher, while the upper trendline is drawn when the price pivots lower. The steepness of inclines and declines determine the direction of the price channel’s trend. An upward trending price channel will have trendlines with a positive slope indicating that the price is trending higher with each price change.
A downward trending price channel will have trendlines with a negative slope indicating that the price is trending lower with each price change. The two lines of a price channel represent support and resistance. Support and resistance lines can provide signals for profitable investment trades.
Price channels are quite useful in identifying breakouts, which is when a security’s price breaches either the upper or lower channel trendline. Additionally, traders can also trade within the channel—sell when price approaches the channel’s upper trendline and buy when it tests the channel’s lower trendline.
Price Channel Analysis
Potentially, there are a few ways to benefit from correctly identifying price channels. Investors, using both long positions and short positions, have the greatest opportunity to gain when security follows a delineated price channel path.
Optimizing profits in an uptrends relies on establishing buy positions in security at advantageous levels. Once a price channel has been identified, the investor can likely expect a security to reverse course and rise when its price reaches the channel’s lower bound. This enables them to initiate a buy position at a discount price. In an upward trending price channel, a bullish investor may want to keep their holdings at the upward bound in anticipation of a breakout, which would lead to a surge in price. If the security appears likely to remain within its price channel, selling out or taking a short position at the upward bound can maximize profitability.
Conversely, a downward trending price channel can also be quite profitable. In a downward trending price channel, investors would want to short the stock at the upper bound and take an even deeper short position once a breakout is confirmed. They could also go against the prevailing trend and take long positions from the lower bound, anticipating price action to adhere to the established channel boundaries and head back up.
Channeling: Charting a Path to Success
The channel is a powerful yet often overlooked chart pattern and combines several forms of technical analysis to provide traders with potential points for entering and exiting trades, as well as controlling risk. The first step is to learn how to identify channels. The next steps include determining where and when to enter a trade, where to place stop-loss orders, and where to take profits.
In the context of technical analysis, a channel occurs 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. The channel can slant upward, downward, or sideways on the chart.
- Trading channels can be drawn on charts to help see uptrends and downtrends in a stock, commodity, ETF, or forex pair.
- Traders also use channels to identify potential buy and sell points, as well as set price targets and stop-loss points.
- Ascending channels angle up during uptrends and descending channels slope downward in downtrends.
- Other technical indicators, such as volume, can enhance the signals generated from trading channels.
- How long the channel has lasted will help determine the trend’s underlying strength.
If price breaks out of a trading channel to the upside, the move could indicate that the price will rally further. For example, the chart below shows a channel and breakout in Hyatt Hotels Corporation (H) stock. If the price breaks below the bottom of the channel, on the other hand, the dip indicates that more selling could be on the way.
The trading channel technique often works best on stocks with a medium amount of volatility, which can be important in determining the amount of profit possible from a trade. For instance, if volatility is low, then the channel won’t be very big, which means smaller potential profits. Bigger channels are typically associated with more volatility, meaning larger potential profits.
Types of Channels
A channel consists of at least four contact points because we need at least two lows to connect to each other and two highs to connect to each other. Generally speaking, there are three types:
- Channels that are angled up are called ascending channels.
- Channels that are angled down are 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
Channels can sometimes provide buy and sell points and there are several rules for entering long or short positions:
- 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 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 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. For example, an ascending channel is depicted below in NVIDIA Corporation (NVDA) shares.
During a descending 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.
Other forms of technical analysis are sometimes used to enhance the accuracy of the signals from the channel and verify the overall strength of the up or down move. 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 high volume. If the volume isn’t rising on a breakout, there is a greater likelihood the channel will continue.
Determining Stop-Loss and Take-Profit Levels
Channels can 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, but also set a stop-loss order slightly below the bottom of the channel, allowing room for regular volatility.
- 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 order slightly above the top of the channel, allowing room for regular volatility. Here is a descending channel in BCE Inc. (BCE) along with potential stop-loss and exit points.
Determining Trade Reliability
Channels provide the ability to determine the likelihood of success with a trade. 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 selling 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.
Trading channels can look different depending on the time frame selected. For example, a channel on a weekly chart might not be visible on a daily chart.
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, buy and sell signals, as well as stop-loss and target levels, can be estimated. 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.
Forex Training Group
As a forex trader, you have come to appreciate the value of trends in the market. Today we will discuss one of the techniques to analyze and trade price tendency in Forex, specifically the price channel method. The price channel, is a version of the standard trend line but displays an additional parallel trend line. And so within the structure of the Channel, the price trend has clearly stated limits for its tops and bottoms.
The Channel Trading Method
So how do we go about drawing a channel on the chart? We start by looking at the price action and try to spot a trending price move where the tops and the bottoms are moving with the same intensity. In the case of an uptrend, we can draw a line which goes through the bottoms and another line parallel to it, which goes through the tops of the price action. Voila! You have just drawn a channel on the chart!
Above you see a standard trend channel drawn on a bullish tendency. The lower level of the channel is a typical bullish trendline which goes through the bottoms of the price action. The upper level is parallel to the lower trendline and connects the diagonal boundary for the topping price action. This creates the classic price channel.
Let take a closer look at the example above. The lower level of the channel plays the role of a support and the upper level acts as a resistance. The black arrows on the chart point to the support and resistance channel function on the chart. See that when the price decreases to the lower level of the channel, it bounces upwards. Then the price seeks interaction with the upper level of the channel and tends to bounce downwards and vice versa.
Knowing this, traders can use channel levels for entry and exit points. When the channel is bullish, you can look for opportunities to buy the Forex pair as price bounces from the lower level. You can hold the trade until the price approaches the upper level of the channel.
In this manner are seeking to trade the impulse move of the channel. When the price bounces from the upper level of the channel, you can trade the potential bearish move to the lower level. However, this is generally less desirable, since the corrective price moves are relatively smaller than the impulse price moves of a trend.
As with all price trends, the tendency within a price channel must also come to an eventual end. We have a channel breakout when the price goes through its upper or lower level, and closes strongly beyond that level. In this manner, the price action exits the channel, and ceases to conform within its previous contained structure. Here is an example of a trend channel breakout:
Above you see the continuation of the channel we were discussing earlier. As you see, the price stops conforming to its levels at some point and breaks through its lower level (red circle). This is the channel breakout. The price goes through the lower level, indicating that the bearish influence on the Forex pair is strong enough to interrupt the bullish trend. A new bearish tendency starts afterwards. The price enters a bearish trend and accounts for a strong decrease.
Channel breakouts warn of a termination of the existing trend, and a potential price moves in the direction of the break. As such, traders can prepare to enter deals in the direction of the breakout in order to catch a new upcoming price move. This is a simplified explanation of a channel breakout trading strategy.
Price Action Trading Using Channels
As we have touched on earlier, price action channel trading in Forex involves trading the inside bounces of the channel. In addition, when the channel has matured, you can then prepare to trade the eventual breakout as well, which could lead to a reversal price move. Let me now show you how this works:
Above you see the hourly chart of the EUR/USD for May 5-12, 2020. The image illustrates a price action system using a channel.
The chart starts with a rapid price decrease, which creates a bottom (1). This is actually the first point of the channel, which is currently being created.
The further price action sends the price upwards, creating a top (2). Then we see a push lower, which sends the price downwards to point (3). The further price increase stops at point (4), confirming the channel.
This is the first trading opportunity on the chart – at point (4). When the price touches the upper level of the bearish channel for second time, it creates a potential for a short trade. The further price bounces create two more long trades and two more short trades. Though we should note, once again, that since this is a bearish channel, we would prefer to trade to the short side, and wait for a channel breakout prior to looking for a long trade.
Take a look at the last short opportunity in the channel. See that the price bounces downwards, but it doesn’t reach the lower level. The price returns back to the upper level and breaks it upwards (red circle). Breaking the upper level the price action creates a close signal for this short trade. However, at the same time, the price creates a long signal for a new trade, since we now have a bullish breakout of the bearish channel.
The price moves sharply higher after the breakout. You would have two options to exit this long breakout trade. The first one is when the price reaches the $1.1435 resistance and bounces downwards. The second option to close the long breakout trade is when the price breaks the support created after the bounce from $1.1435. In both exit options the trade would have been profitable.
Linear Regression Channel
One of the more popular channel indicators is the Linear Regression Channel. This type of channel indicator looks similar to a standard channel however, the Linear Regression Channel indicator has a middle line, which is a median price value. The upper and the lower level are evenly distanced from the median line.
In this manner, the middle line of the Linear Regression Channel also acts as a support or a resistance. Furthermore, this line could be used as a trigger to enter trades in the direction of the trend. Have a look at the image below:
This is a standard Linear Regression Channel. You see the upper level, the lower level and the median line. The black arrows on the chart image point to moments when the channeling price action reacts to the median as a support or a resistance.
After a bounce from the median line, the price usually returns to where it came from. At the same time, when the price breaks the median level, we see a further move to the opposite channel line.
Traders can use the median level of the Linear Regression Channel as a confirmation for their trades. At the same time, the median line could be used to attain exit signals as well.
The Donchian Channel is another channel trading indicator. The Donchian channel indicator is calculated by taking the highest high and the lowest low of N p eriods. These highs and lows are marked by horizontal lines, with dynamically changing levels depending on the highest high and the lowest low for the progressing periods. As such, the price action is encapsulated by the Donchian price channel.
The Donchian trading indicator also has a middle line. This line is simply the average between the upper and the lower Donchian levels.
The upper and the lower level have support/resistance functions. However, when the price starts to continuously hit the upper band, and prices continue to rise, then we get a long signal on the chart. The same is in force for the lower band. If the price action starts hitting the lower band of the Donchian channel and pushes it downwards, then you get a short signal.
In other words, expanding the distance between the upper and the lower channels gives us a bias on the price dynamics and the formation of a trend. At the same time, the middle band can be used as a further confirmation of entry or exit signals.
You may have noticed that the Donchian channel indicator resembles the Bollinger Bands indicator. Indeed, they are used in a similar way. However, we must understand the difference between the two. The Donchian indicator is based on the price high and low over x periods, while the Bollinger Bands indicator has a volatility based configuration.
The image below will show you the Donchian channel indicator and illustrate a Forex channel trading scenario:
Above you see the Donchian channel strategy. It looks pretty chaotic, however, once you understand what to look for, this initial chaos begins to make sense. When the two bands are tight, the Donchian bands act as support and resistance. In this phase, price bounces up and down between the two bands. We consider this a consolidation period or ranging market condition. You can still trade the bouncing price moves between the two bands, but this is not the best application of the Donchian trading method.
The most attractive function of the Donchian indicator in recognizing strong momentum breakouts. We see this when the price starts hitting the upper band, moving it upwards or starts hitting the lower band, moving it downwards. The green arrows on the image point out when the price creates higher highs.
In this manner, the upper Donchian band starts moving upwards too. This means that the price is increasing with relatively high intensity, creating a suitable entry in a long trade. Then the bands get tight again. The price starts testing the upper and the lower bands as resistance and support. Suddenly, the price action starts hitting the lower Donchian band, creating lower lows (red arrows). This creates a short opportunity on the price chart.
Referring to the image above, the proper place to go long would have been with the first green arrow on the chart. This is where price has closed above the previous consolidation level, and has been testing the upper Donchian channel over the last few periods, in a possible attempt to breakout to the upside. The trade could be held until the price breaks the middle band downwards. This is the exit signal from the trade. As you see, this is actually where the bands are getting close to each other and the pair starts to range.
In order to trade the subsequent price decrease you would apply the same logic as we used for the long example. The optimal place to short the pair is marked by the first red arrow on the chart. This comes after the price bounces from the upper band and after price has closed below the Donchian support level.
Meanwhile, the two bands are just starting to expand which provides us a clue that a further price decrease is probable. We see that every bottom is lower than the previous one and the lower Donchian band is decreasing with every further period. We can conclude based on this price action behavior that the down run is relatively strong. The short trade during this price run should be held until the price breaks the middle band upwards. This happens with the last candle on the chart.
Which is the Best Channel Trading System for You?
Channel trading applied to currency pairs is a simple, effective technical analysis practice that can help forex traders stay on the right side of the market. Each of the three channel trading systems we discussed have their positives and negatives.
If you are a beginner, it might be better for you to use the simple price action channel trading method. Pick the price lows and highs during a trend and draw a channel. Then simply trade the bouncing moves inside, preferably in the direction of the existing trend. Also, do not forget to watch closely for the breakout move. After all, the channel breakout could likely lead to a sharp price move in a relatively short period of time.
If you are more of a cautious trader and you always want additional confirmation for your channel trading system, then the Linear Regression Channel might be the right channeling tool for you. Find your two highs and lows and stretch the Regression Channel over it. Then look for the bounce from the upper and the lower levels, followed by a breakout through the median level. For the conservative trader, the median line can provide that additional layer of confirmation. But be cognizant that by waiting on this additional confirmation, the profit potential will likely be lower on your trade as well.
Finally, if you feel that you are more experienced and you like the idea of using a bit more complex, dynamic, support resistance level, then you may like the Donchian Channel method. Look for times when the price has broken a recent S/R level and starts hitting the upper or lower band, creating a pressure in the respective direction. Enter a trade if the two bands are expanding. Then if your trade is properly implemented, and the price continues in the intended direction, you should look to hold your trade until the price action breaks the middle band in the opposite direction.
- Price channels in Forex are one of the most basic price action concepts that traders should be aware of.
- Channels are created when price action creates tops and bottoms with the same intensity.
- If you are able to draw two parallel lines through the tops and the bottoms of the price action then you have a Price Channel on the chart.
- Traders use channeling techniques to set entry and exit points for their trades.
- A basic Channel trading strategy entails entering a trade when the Forex pair bounces from one of the channel line extremes. The trade should be in the direction of the bounce and should be held until the price approaches the opposite level of the channel.
- In Channel trading the price bounces that occur in the direction of the trend are more attractive to trade. The corrective price moves are shorter and riskier.
- The end of a Channel comes with the Channel Breakout, which is likely to lead to a counter trend price move in the direction of the break.
- The Linear Regression Channel is a variation of a regular channel. The difference is that the Linear Regression channel has an additional line in the middle of the upper and the lower level. This line is parallel to the two levels and it is a median value of the channel.
- The Donchian Channel indicator creates horizontal levels for every X highest and lowest period on the chart. Therefore, the Donchian channel embraces the price action within that designated period. The preferred Donchian signal is created when the price starts hitting the upper or the lower band, moving it further. This creates a signal in the direction of the band hit. The Donchian Channel also has a middle line, which is the average between the upper and the lower band.
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A price channel is a continuation pattern that slopes up or down and is bound by an upper and lower trend line. The upper trend line marks resistance and the lower trend line marks support. Price channels with negative slopes (down) are considered bearish and those with positive slopes (up) bullish. For explanatory purposes, a “bullish price channel” will refer to a channel with positive slope and a “bearish price channel” will refer to a channel with negative slope.
Main Trend Line: It takes at least two points to draw the main trend line. This line sets the tone for the trend and the slope. For a bullish price channel, the main trend line extends up and at least two reaction lows are required to draw it. For a bearish price channel, the main trend line extends down and at least two reaction highs are required to draw it.
Channel Line: The line drawn parallel to the main trend line is called the channel line. Ideally, the channel line will be based off of two reaction highs or reaction lows. However, after the main trend line has been established, some analysts draw the parallel channel line using only one reaction high or low. The channel line marks support in a bearish price channel and resistance in a bullish price channel.
Bullish Price Channel: As long as prices advance and trade within the channel, the trend is considered bullish. The first warning of a trend change occurs when prices fall short of channel line resistance. A subsequent break below main trend line support would provide further indication of a trend change. A break above channel line resistance would be bullish and indicate an acceleration of the advance.
Bearish Price Channel: As long as prices decline and trade within the channel, the trend is considered bearish. The first warning of a trend change occurs when prices fail to reach channel line support. A subsequent break above main trend line resistance would provide further indication of a trend change. A break below channel line support would be bearish and indicate an acceleration of the decline.
Scaling: Even though it is a matter of personal preference, trend lines seem to match reaction highs and lows best when semi-log scales are used. Semi-log scales reflect price movements in percentage terms. A move from 50 to 100 will appear the same distance as a move from 100 to 200.
In a bullish price channel, some traders look to buy when prices reach main trend line support. Conversely, some traders look to sell (or short) when prices reach main trend line resistance in a bearish price channel. As with most price patterns, other aspects of technical analysis should be used to confirm signals.
Because technical analysis is just as much art as it is science, there is room for flexibility. Even though exact trend line touches are ideal, it is up to each individual to judge the relevance and placement of both the main trend line and the channel line. By that same token, a channel line that is exactly parallel to the main trend line is ideal.
CSCO provides an example of an 11-month bullish price channel that developed in 1999.
Main Trend Line: The January, February, and March reaction lows formed the beginning of the main trend line. Subsequent lows in April, May, and August confirmed the main trend line.
Channel Line: Once the main trend line was in place, the channel line beginning from the January high was drawn. A visual assessment reveals that these trend lines look parallel. More precise analysts may want to test the slope of each line, but a visual inspection is usually enough to ensure the “essence” of the pattern.
Bullish Price Channel: Subsequent touches along the main trend line offered good buying opportunities in mid-April, late May and mid-August.
The stock did not reach channel line resistance until July (red arrow) and this marked a significant reaction high.
The September high (blue arrow) fell short of channel line resistance, but only by a small margin that was probably insignificant.
The break above channel line resistance in Dec-99 marked an acceleration of the advance. Some analysts might consider the stock overextended after this move, but the advance was powerful and the trend never turned bearish. Price channels will not last forever, but the underlying trend remains in place until proved otherwise.
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