The channel is a simple and effective technical analysis tool for charting and trading on a price trend. Channels can be used to identify a trend and the possible points of a reversal or a price breakout to a different trading level.
What Is A Channel And How Is It Identified?
Channels are customarily created by pinpointing the upper and lower limits of price action within an ongoing price trend on a chart and drawing lines through those limits to establish a moving horizontal reference for support and resistance levels over time. The space between those lines on the chart forms the channel. The support line is considered to be the "main trend line," and resistance is referred to as the "return line." To draw the lines, analysts typically wait for at least three price movements to peaks on the upside, and three movements downward to troughs.
The reason to wait for three peaks and troughs is that a smaller amount is understood to be potentially misleading when a price possibly moves outside of what was thought to be the trend. Channels are typically in diagonal upward or downward positions, but they can also be in level positions during range-bound "sideways" market movements.
How Channels Are Used
A price channel can help traders identify the best entry points for trades while still helping limit the amount of upside or downside risk they assume. Trades executed within the channel are considered to be in line with the current trend and reduce traders' exposure to possible extreme movements to unpredictable price levels. They are generally used for short- and medium-term trading, and they're considered less effective for use in long-term trading.
Trading On An Upswing
Once a channel has been established, traders can monitor for price swings lower in order to enter a long position near the level of support. With the direction of the trend, traders can feel reasonably confident that the price will begin a move higher toward resistance. To guard against a potential unexpected move lower, they can then set a stop-loss just below the line of support. The upward line of resistance then provides an ideal level for setting a profit target, because there is a reduced chance that price will break above that level.
Trading On A Downswing
The process for entering a trade during a downward swing is similar, but in the opposite direction. Traders can enter a short trade following an upswing of the price within the channel toward the level of resistance. A stop-loss can be set just above the line of resistance to protect against an unforeseen move higher, while a profit target is set near the line of support to exit the trade.
Assuming Risk For Larger Gains
Traders who are willing to accept greater risk in search of higher profits may want to wait to set their profit targets until the price "bounces" off resistance following an upswing, or off support following downswing. This strategy could allow for a wider range of entry and exit in case the price continues to move outside of the channel.
Breakouts And Reversals: Don't Bet Against A Break
Once the price breaks definitively outside of a channel, it is unlikely to return immediately, and traders should expect an alteration in dominant price levels. Signals for the change of a trend can also occur within the channel, particularly for reversals.
If the price fails to return to near the established resistance or support lines following a series of swings and turns near the middle of the channel, it is a strong sign that the dominant trend is changing direction. In these instances, traders may want to consider taking long or short positions aiming at price targets outside of the channel. However, reversals are sometimes characterised by periods of volatility, so traders will want to exercise caution in making this decision.
The channel is a very common, simple and useful tool in technical analysis that helps traders determine a safe and predictable range in which to execute trades. Traders can reliably go long near the bottom of a channel with the expectation that the price is unlikely to surpass resistance in its subsequent movement upward. Similarly, they can trade short on a downward move with confidence that the price will find a floor near the established support line. And when breakouts and reversals do occur, the channel will provide a helpful indicator for whether to adopt a trend- or range-based trading strategy.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…