Think of a price channel like a river. Similar to banks that contain water, a channel contains the price. We have ebbs and flows in price, just like the water weaving through a channel. To identify it on a chart, just look for the parallel lines that bind the stock‘s price. Depending on which way the trend or water is flowing, we see either a horizontal, ascending or descending channel.
As a new trader, you’re going to want to pay close attention to price channels. There are a few reasons why but the most important takeaway is this. A price channel helps you to identify two things: the direction of the price and the momentum.
How to Use a Price Channel
- A price channel happens when the price of a security oscillates between two parallel lines.
- They can be horizontal, ascending, or descending.
- They help you to identify breakouts and breakdowns
- Sell when price approaches the upper channel trendline
- Buy when price tests the lower trendline of the channel.
What Type of Securities Experience Price Channels?
Any and all. You can spot the channels in any instrument from futures to stocks, mutual funds and even exchange-traded funds.
In fact, you can look for wolfe waves as well. If you’ve been in our Futures trade room or regular room on Thursday’s then you know all above wolfe waves and channels.
A Deeper Dive
The forces of supply and demand are the driving forces behind the formation of channels. Like I mentioned above, we see upward, downward or even sideways trending channels.
A stock in high demand creates a strong surge upwards in price. Alternatively, you’ll see a steep descending channel in a stock experiencing a panic sell-off.
Sometimes price just casually flows along without any push and pull momentum. And as expected, price channels can happen during any time frame; 1-minute, 5-minute, over 4-hours, it doesn’t matter.
Who Uses Price Channels?
Pretty much any trader. Especially those who focus on the technicals or are on the lookout for channels.
The price boundaries created by channels tell a trader when to enter and when to exit. In fact, you can use these for support and resistance.
And those are the most important levels to pay attention to. Stocks respect support and resistance so much it’s not even funny.
How to Draw Price Channels
As a kid, do you remember playing connect the dot games? I know I do, and it’s no different when drawing channels for price. At the point where price pivots higher, draw the lower trendline. Similarly, when the price pivots lower, draw the upper trendline. What results is a channel, and the steepness determines the direction of the price.
Positive sloping trendlines bound an upward or ascending price channel. You can see this in #1 of the picture above.
This positive slope means the price is trending higher with each price change. It should come as no surprise that a descending price channel has negatively sloping trendlines.
And thus, the price is trending downwards with each price change. It’s not quite like forming triangles, however. So you may not see any channels forming descending triangle patterns.
Using Support and Resistance Lines as a Trading Strategy
If you haven’t figured it out yet, the two lines of a channel are support and resistance areas. And if you can identify them correctly, you can make money.
Trading Breakouts
For starters, let’s look at the breakout. A breakout happens when price breaches either the upper or lower channel trendline.
As a trader, you spot a breakout by identifying an upward trending channel. Next, you’ll see a surge in volume and a breakthrough in the trendline.
If you can spot a breakout in the making and enter at the right time, there’s money to be made.
A Word of Caution: False Breakouts
A breakout doesn’t mean the price will continue in the direction you think it will. Sometimes, you could be seeing a false breakout. What is one to do?
For starters, you need to verify it is, in fact, a breakout. And this is where volume comes into play. We use volume to confirm uptrends like breakouts, downtrends and overall chart patterns (i.e. head and shoulders, flags, cup and handle etc.).
Trading the Channel
- Do you know when to trade within the channel?
- Sell when price approaches the channel’s upper trendline
- Buy when it tests the channel’s lower trendline.
- Just take a look at the image below.
Conversely, there’s money to be made in the downward channel as well. In the scenario above, you go long when price breaks through the upper band.
However, in some cases, the price can’t break through the upper channel. Traders look to short the stock at the upper bound and take an even deeper short position once a breakdown is confirmed.
Nail Down Your Channel Trading Strategy With This One Indicator
I need to let you in on a little secret to trading channels: Moving averages. From identifying support and resistance areas to the strength and direction of a trend, there are a lot of ways moving averages can help you.
For starters, a price that is far away from the moving average indicates a weak trend. A weak trend means a potential reversal is on the horizon.
Equally important, the direction of the moving average reflects the stock’s price. A rising moving average means prices are rising.
Likewise, a falling moving average indicates prices, on average, are falling. A rising long-term moving average characterizes a long-term uptrend. Hence, a long-term downtrend is characterized by a falling long-term moving average.
Final Thoughts
Trading channels is one of the smartest ways to make money trading. It doesn’t matter whether you’re a swing trader, day trader or scalper, the channel trading strategy will work for you.
Given the fact that channels provide potent signals for profitable trades, I suggest you take the time to learn them.
