Table of Contents
What Is Channel Trading
Channel trading is an underrated chart pattern trading method, used in the continuation of an established trend, as part of a trend following strategy. The channel offers traders precise points of entries and exits from the market. A channel forms when price action controlled by two parallel trend lines tested each of these lines at least twice.
Trend Channel – Trend Line Analysis
What is a Trend Line
If you are planning to trade price channels, you first need to determine the main trend on the market. That’s why a key component of this process is to identify the relevant trend lines. Trend line analysis is often underestimated by many traders.
The process of drawing trend lines on a chart it is perceived as being subjective. Although this is not entirely false, the trend line analysis should be the first step in determining the existence of a trend.
Trend lines are straight lines drawn on a chart connecting support swings when the price trades in an uptrend or resistance swings during a downtrend.
A trend line may rise, fall or move sideways.
- In an uptrend, we look to connect the lows of the price
- In a downtrend, we connect the highs of the price
How to Draw Trend Lines in Channel Trading
Drawing trend lines should be an easy task for every trader. During an uptrend, a trader must look to connect the lows of the price. In a downtrend, the trader connects the highs of the price.
A valid trend line must connect two or more points that define the trend.
Here are the main steps you should follow during your process:
- When you start your trend line analysis, you should start drawing the chart trend lines on higher time frames. You want to identify the trend lines with a higher relevance, which offer less noise.
- After you determined the main trend lines on the higher time-frames, you may proceed to shorter time frames and spot the relevant trend lines
- Once you identify the main areas of support and resistance on all timeframes, you should pay attention to the levels on the higher time frames.
- A trend line that has a positive slope will act as support during an uptrend. As long as the market price remains above this trend line, the uptrend is considered intact.
A close of the price below the uptrend line suggests a possible change in momentum. A breakout below an upward trend line should be considered a warning sign, but not a sure thing that a reversal to the downside will happen.
- A trend line that has a negative slope acts as resistance during a downtrend. As long as the market price remains below this trend line, the downtrend is considered intact.
A close of the price above the downward line suggests a possible change in momentum. A breakout above a downward trend line should be considered a warning sign, but not a sure thing that a reversal to the upside will happen.
Trend Lines Relevance for Channel Trading
The relevance of a trend line forming a channel is determined by its length, its number of retests and its slope.
Trend Lines Length
The length of the trend line is an important factor for channel trading. A 1-2 days trend line is of minor importance if you are swing trading, for example.
A trend line which acted as a support or resistance in the past month, for example, would have a bigger relevance. A breakout from that level could represent an important signal for market participants.
That’s why it’s better to focus on support and resistance levels on the higher time frames.
Even if you are scalping and trading on the 5-min chart, you must try to find a channel on higher time frames, and enter your position based on those trend lines.
The main problem with the trend lines on lower timeframes is that they generate a lot of market noise. The risk of getting whipsawed is much higher when you are trading based on minor trend lines.
Number of Trend Line Retests
A trend line is more important if it has been retested many times in the past. Each trend line retest contributes to the relevance of support or resistance.
A trend line which includes only 2 recent market swings, for example, is an easy target for a possible breakout or false breakout.
That’s why the general consensus is that a trend line which has been retested at least 3 times is considered relevant to market participants.
Trend Line Slope Angle
A very steep trend line is difficult to be maintained and is therefore likely to be easily broken, even by short lateral movements.
Of course that all the trend lines are eventually broken, but the steepest trend lines are the soonest broken. Usually, a breakout of a trend with a steep slope is more likely followed by a trend continuation than a reversal.
A steep trend line is often the result of an accelerated increase or decrease in the short term. This translates into a short price burst, without any relevant price corrections. In this case, the trend line will have a higher angle and is less likely to provide solid support or resistance.
From my experience, trend lines with 30-45 degree angles are the best one to follow when channel trading.
Stock Channeling – Trading Patterns
Ascending Channel
- represents a chart pattern indicating an uptrend
- the support trend line connects consecutive higher lows
- the support trend line is also called the demand line.
- the resistance line connects consecutive higher highs.
- the support trend line of an ascending channel represents a buy zone
- long positions are taken at the demand line
- stop losses orders are placed below the support trend line
- take profit orders are placed at the other end of the channel, around resistance trend line
Descending Channel
- represents a chart pattern indicating a downtrend
- the support line connects consecutive lower lows
- the resistance line connecting consecutive lower highs.
- the resistance line is also called the supply line
- the supply line of a descending channel is a sell zone
- short market entries are taken at the supply line
- stop losses orders are placed above the resistance trend line
- take profit orders are placed at the other end of the channel, around support trend line
Bull Flag
- Flags are continuation patterns, indicating a small pause in the market trend
- Bull flag patterns can be spotted in an uptrend
- the market breaks out from a range and makes “lower highs” and “lower lows” in a tight formation
- The trend lines connecting these highs and lows are near parallel.
- when spotted, breakout traders look for an upside breakout in order to enter the market
- trend traders look to buy at the lower trend line of the channel
- stop losses orders are placed below the support trend line
- take profit orders are placed at the other end of the channel, around resistance trend line
Bear Flag
- A bear flag usually occurs as markets consolidate during a downtrend.
- They are almost identical to bull flags but in the opposite direction.
- A bear flag can be easily spotted as it makes “higher highs” and “higher lows” within the “flag” area.
- The trend lines connecting the swing highs and the swing lows are almost parallel.
- when spotted, breakout traders look for a downside breakout in order to enter the market
- trend traders look to sell at the upper trend line of the channel
- stop losses orders are placed above the resistance trend line
- take profit orders are placed at the other end of the channel, around support trend line
Channel Trading with Technical Indicators
A channel is not necessarily defined as the area between two parallel trend lines. A channel can also be spotted when we plot specific technical indicators. Here are the most efficient technical indicators assisting traders in finding price channels.
Bollinger Bands
Bollinger Bands is a popular indicator used by traders to analyze the dynamics of the price on the market. Bollinger Bands consists of 3 lines:
- The middle band, representing a simple moving average (most common value is 20)
- The upper band, which is the period + N standard deviations (usually 20 + 2 STD)
- The lower band, which is the period – N standard deviations (usually 20 – 2 STD).
In channel trading, the upper and lower Bollinger bands act as dynamic support and resistance levels.
The most efficient method of trading channels with the Bollinger Bands is to find an area of confluence between the indicator and a trend line.
In order to increase your chances, you should only look for trades in the direction of the main trend in the market:
- During an uptrend, traders look to buy at confluence area between the lower trend line of an ascending channel and the lower Bollinger Band
- During a downtrend, traders look to sell at confluence area between the upper trend line of a descending channel and the upper Bollinger Band
Keltner Channel
Keltner Channel is a technical indicator calculated based on an exponential moving average and the Average True Range.
This indicator is similar to the Bollinger Bands. Thus, the upper and lower bands of the Keltner Channel can act as a dynamic resistance and support areas during channel trading.
- During an uptrend, traders look to buy at confluence area between the lower trend line of an ascending channel and the lower Keltner Channel
- During a downtrend, traders look to sell at confluence area between the upper trend line of a descending channel and the upper Keltner Channel
Donchian Channel
The Donchian Channel is another great indicator to identify dynamic support and resistance levels in a channel.
This indicator analyzes the evolution of the price by plotting the highest high and lowest low over a specific time interval.
- During an uptrend, traders look to buy at confluence area between the lower trend line of an ascending channel and the lower Donchian Channel
- During a downtrend, traders look to sell at confluence area between the upper trend line of a descending channel and the upper Donchian Channel
Channel Trading Strategy – Stocks Channeling
Trading channels is one of my favorite methods. In combination with other indicators to pinpoint the entries, this strategy will keep you on the right side of a trend. Let me explain the strategy:
1. in the first phase we need to identify the demand line, by connecting two higher lows in a possible uptrend
2. we extend the supply line at the upper side, connecting at least 2 market highs (this will serve as the supply line)
3. we add the Ichimoku indicator but we plot only the Kumo cloud, for a better graphical representation – Kumo cloud will serve as a dynamic area of support and resistance
4. we seek for long entries near the supply line
5. for better entry points, we move to lower timeframes and enter the market only if the Kumo cloud confirms the dynamic area of support (see below)
– an aggressive entry would be at the touch of the trendline, as seen in the example above
– a more conservative entry would require a bullish candle, or at least a doji candle, to confirm the rejection of the area
Channel Trading – Advantages
• excellent at identifying support and resistance areas
• help traders to take positions in the direction of the prevailing trend on the market
• offers accurate target prices and optimal entries on the market
• offers an early warning about the current market price
