The basis of median channel work is rooted in Isaac Newton’s third law of motion that for every action, there is an equal and opposite reaction. A brief history of the methodology tells us that pioneers in applying these laws to the technical analysis of financial markets were Roger Babson and George Marechal.
It was Marechal who copyrighted a famous Dow forecast chart that Alan H. Andrews, the founder of Andrews’ Pitchfork, described in his original course as a "chart no government economist, no college professor has enough knowledge to even approach or courage to try to duplicate." It was a chart created in 1933 that turned out to be an accurate forecast over the next 15 years.
Most charting packages will include Andrews’ Pitchfork and calculate it for you. You simply set it at three points in the direction of a trend starting with a low or high and then the following low and high. According to Andrews, the median lines attract the price action 80% of the time. It’s really a simple method, but it is largely overlooked as just another indicator on most software packages. However, it is as powerful as it is simple, and here we will look at some of its more advanced applications.
Word of warning
Parallel warning lines are the same distance from the median line, or mid-line. The best application of the parallel warning lines is to project long-term support or resistance. On a long-term chart of crude oil, we have the classic median channel drawn from a low in 1986 to the next most important high in 1990 and then the next important bottom in 1998 (see "Oil lines," below).
As you can see, a channel formed that was close to the high in 2005 and the congestion area in 2006. The mid-line also came close to catching the exact bottom of the pullback in early 2007. Given that the channel lines did work, we can have confidence to use them again.
Just because the slope isn’t steep doesn’t make the channel lines less valuable. They turned out to be invaluable in identifying the top. The pattern went out exactly three channels, or warning lines, before it almost perfectly caught the top. At the point in time where the 147 top came in, the channel line was sitting at approximately 144. If that wasn’t enough, the original median channel helped capture the bottom of the commodity crash several months later. There was no other method that came close to this kind of accuracy.
For another example, consider the complete bear market in the BKX banking sector index (see "Over the edge," below). The common channel was drawn to accommodate the bull market from 2002-07. There are at least three and possibly four good validations. Notice how most of the pattern resides in the lower, weaker portion of the channel. This is an important point that we’ll return to later. For now, notice how the bear market raced down four equidistant levels to catch a perfect bottom. The parallel warning lines can cluster with other data or indicators to make a stronger magnet point. When we understand that the BKX and crude oil are responding to an important warning line, it has broad implications for the entire market. A reversal in oil on a parallel line can affect trading decisions on just about any energy or commodity/inflation-based chart.
Another key use of parallel warning lines is navigating through a parabolic drop. One of the best examples materialized in May 2010 during what became known as the "flash crash." Any parabolic event is emotional. One of the biggest reasons traders lose money is because they make emotional mistakes. Emotional mistakes generally are made because traders don’t understand the pattern in play.
The flash crash was a unique event because of the parabolic drop and recovery. It was so unique, in fact, that market participants and the media blamed it on an institutional trader’s fat finger. Most market participants had no idea what happened, and the exact cause probably never will be known. However, by navigating the drop with the parallel warning lines, you would at least have an understanding of what was happening.
The bottom finally materialized at the drop of two full median channels. Probably just as important was the aftermath of the event. That period was even more difficult to understand because it’s difficult to estimate support and resistance levels after any kind of a crash. In this case and many others, the parallel warning lines will act as support and resistance until the market gets back into a normal flow again. There also was another flash crash event in cocoa at the end of September 2010, and that one found a low close to the parallel warning line.
The parallel warning lines that come off the basic pitchfork channel are useful in identifying a trend in any time frame, but this is not the only application of this tool.
Many traders use the ADX indicator to determine the strength of an underlying trend. That may work well on a daily or weekly basis, but the ADX does not work well on intraday trends.
To determine the underlying strength of a trend on an hourly time frame or smaller, it may be helpful to think of the median channels as a flowing river. Bodies of water flow into larger bodies of water because they follow the path of least resistance. Median channels work much the same way. Think of the zones on either side of the mid-line as the path of least resistance. In a bull move, the zone north of the mid-line will have greater relative strength than the zone south of the mid line. In a downtrend, it is just the opposite. This may seem obvious, but take away the pitchfork entirely and you couldn’t tell the difference.
A good example of determining the strength of an intraday pattern can be seen in a recent pullback phase in the biotechnology sector index (BTK) (see "Bio break," below). In the initial phase, the pattern is attracted to the lower, weaker zone of the bearish median channel. After a couple of retests over the next month, the pattern finally spends the majority of the time in the upper portion of the channel. The downtrend is not confirmed over until it breaks out of the channel. Behavior leading up to the breakout can be viewed as an advance warning or indicator of what is to come. That is a warning that a bearish sequence is not going to be sustainable.
On the flip side is a median channel of the greenback that immediately catapulted itself and spent the majority of time in the stronger part of the channel, north of the mid-line (see "Strong-side dollar," below). When it pulled back, it did so close to the mid-line. The best way to answer whether a pullback is buyable is if the pattern spends its time north or south of the mid-line.
If the best a pattern can do is rally up to the mid-line, chances are it will fail when it tests the lower rising line. If it rallies up to the higher outside line, chances are good it will be buyable when it comes to the mid-line. What about the intraday charts? The smaller channel line on the dollar chart is representative of an hourly chart where the pattern spends the majority of time in the upper, less-bearish part of the median channel. That is an indication of internal strength, and eventually the price action did explode higher.
True pattern recognition comes from understanding what clues the pattern is giving. To gain a true edge in trading financial markets it’s important to anticipate what can happen before it actually does. Whether you use the parallel warning lines or just the positioning of the pattern inside the channel, the pitchfork methodology is a tool that will help accomplish that goal with a high degree of precision.
You may not trace a forecast that the market will follow for the next 15 years, as Marechal reportedly did, but you will put the odds on your side if you learn to wield Andrews’ Pitchfork adeptly.
Jeff Greenblatt is the author of "Breakthrough Strategies for Predicting Any Market," editor of the Fibonacci Forecaster, director of Lucas Wave International LLC and a private trader.