Channel trading represents a powerful way to execute trades while capitalising on the market’s tendency to trend. This strategy gives the trade precise information by making use of several types of technical analysis.
The area between a pair of parallel trend lines is referred to as a channel and this represents the range of trades. The price highs are represented by the upper trend line, while the lower one represents the lows of trading prices. Price channels are an essential part of technical analysis and form the foundation of a number of popular trading strategies. These are the lines which are drawn both below and above the asset’s current price and they will remain the same until either a new low or high is created. Price channels are often used as a measure of volatility as well as a price target and to identify support and resistance zones. While channelling is considered to be useful for both medium and short term trading, it is not recommended for long term trading.This strategy works best on assets with a price that shows moderate volatility and is more likely to be successful if the method is used in conjunction with at least one other type of technical analysis.
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A trend channel is formed from two parallel lines running along the low and high prices of an asset’s trend. It is quite normal for these lines to diverge and converge, and if they are converging, they will often form a wedge pattern, with a broadened wedge appearing if the lines diverge. These lines will touch multiple trough and peaks rather than moving across the extremes.
It is normal for the market to not move in a perfect trend channel as the price will generally move below or above the lines of references, therefore when drawing up the trend channel, the line of best fit should be used.
If the trend channel is moving upward, the trader should enter long positions in ascending channels in the same direction as the increasing asset price until there is breakage of the support line. Conversely, a trader should take short positions when the channel is descending. It is always advisable to wait until the prices bounces off the trend line, with long positions being entered into whenever it bounces off the line of support and options being sold when the price comes close to the resistance line. If the price bounces off the resistance line, short positions should be entered into and they should be covered when the price comes close to the support line. At the breakouts of the trend channel, the trader should enter long positions as soon as the price is able to break through the line of resistance or short positions if the price breaks through the line of support.
Types of Channels
There are two types of channel:
This is contained between two parallel lines which slope upwards. This signal indicates an uptrend with higher lows and highs. The trend lines will frame the price channel, with the bottom line being drawn across the pivot lows and the pivot highs forming the upper line. Although the price may not always stay within these channel lines, they are important to show the areas of resistance and support for price targets. A high that is higher than the ascending channel will indicate a change in trend.
A descending channel represents the price action between two parallel lines that slope downwards. This channel will have lower lows and highs. A low that is lower than the descending channel will indicate continuation while a high that is higher than the low of the ascending channel indicates a change in trend.
How to Trade Channels
Channelling is a systematic and simple way of trading. By using this strategy, an investor can identify the best points for selling and buying options. There are several techniques that can be used in conjunction with channelling to produce more successful results.
1. Moving average convergence divergence – this strategy will confirm the channel’s movement, especially after contact.
2. Stochastic – this is a method to confirm the movement of the channel.
3. Volume – this will estimate the strength of the various channel movements, determining the overall strength of the channel.
4. Short term moving averages – this provides an outlook in the short term on a channel play, confirming the changes in direction after making contact.
5. Candlestick patterns – these will determine the breakouts of the channel.
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- Technical analysis of the financial markets: A comprehensive guide to trading methods and applications. Penguin, Murphy, J. J. (1999).
- Global imbalances, triangular trading patterns, and the yen/dollar exchange rate. Journal of the Japanese and International Economies, 22(4), 503-517, Thorbecke, W. (2008)