HOW TO TRADE USING CHANNELS
Channels are another important technical analysis tool used by traders to determine profitable trade set ups on both short and long sides. Channels give precise entry,exit,stop loss and profit booking levels.
What is a Channel
A channel is the combination of an existing trendline and a new, parallel trendline also known as the channel line. The Upper trendline connects the highs and lower trendline connects the lows. Tops and Bottoms of trendline represent demand (support) and supply (resistance) region. Assets Price generally oscillates between the upper and lower trendline, which helps traders to find profitable trade setups ie. Traders can buy near the lower end of channel and sell at higher end. An example of S&P 500 forming an ascending channel on Weekly time frame is shown below.
As seen in the chart above S&P 500 made a low of 1266 on 08June2012 ,after that traveling with the channel forming higher lows and higher highs.
How to create a channel
Channels can be created by following the below steps:
- To Begin the channel trader needs to find swing high and swing low in the chart.
- Once identified, find another high
Types of Channels– Much like trend lines, trend channels can also be classified as uptrend and downtrend. An uptrend channel will climb up and is therefore, considered bullish. The trading rule here is simple- buy when the price comes close to the rising main trend line(with a stop loss arrangement at the trend line value) and book profit when the price comes close to the return line. The active traders who want to make money by participating in the counter trend (one against the main trend) can also consider selling short close to the return lines, with a stop loss in place at the return line value.
A downtrend channel, on the other hand, is bearish and is a falling pattern. The trading rule here is in contrast to that of the uptrend channel, that is ,sell short when the price comes close to the falling main trend line (with a stop loss arrangement at the trend line value) and book profit when the price comes close to the return lines. Here again, the active traders who want to make money by participating in the counter trend can consider going long close to the return lines, with a stop loss in place at the return line value.
- While channel analysis helps investors take advantage of price oscillations, they need to be careful about any break in channels. This is because unlike the trend line analysis, a break in a trend channel is more complicated.
- A break (up or down) in the main trend line signifies that the investors expectation about the stock has changed and therefore it can be used to generate new buy or sell signals. Any decisive break in the downtrend line is a clear buy signal. Similarly, any decisive break in the uptrend line is a clear sell signal. In both the cases, the main trend line value should be used as the stop loss.
- A break in the return line, on the other hand, indicates that the trend is becoming stronger. So traders can consider taking a fresh long position if the price goes decisively above the return line of an uptrend channel. Similarly traders can consider taking a fresh short position if the price goes decisively below the return line of a downtrend channel. However, only seasoned traders should try this because the break may be temporary and the price may get back to the trend channel in a short period.
- The prices that are unable to reach the return line (known as return line failure) also give a hint about a possible trend reversal. In the coal India chart, the prices failed to reach the return line just before the break in its uptrend channel. Since the return line failure indicates that the channel is weakening, investors need to be cautious with their trades when prices come back to the original trend line.
Channels are useful for short-to medium-term trading – not long-term trading or investing. The technique often works best on stocks with a medium amount of volatility. Remember, the volatility determines your profit per trade. Channeling also tends to work best when the technique is combined with other forms of technical analysis,