From the September 01, 2012 issue of Futures Magazine • Subscribe!

Trading channels for profit

Understanding channels

During a trading range, traders scalp by buying near the bottom and selling near the top, both to initiate positions and take profits. 

Channels are weak trends and can behave more like a spike or a trading range. When they are tight and steep with only small and brief pullbacks, they are spikes on higher time frame charts and should be traded like strong trends.

In a steep bear channel with only small pullbacks, traders only should look to short. When a channel is broad with large swings made of pullbacks lasting 10 or more bars, and the slope is relatively flat, it essentially is trading a range. The broader and flatter it is, the more traders will trade in both directions, looking mostly for scalps, as they do in trading ranges. The tighter and steeper it is, the more inclined traders will be to trade in the direction of the trend.

Every type of market has characteristics that make it difficult to trade. The more the market resembles a trading range, the less certain that a breakout or a reversal will hold. The steeper the trend, the higher the probability of success, but the stop usually is farther away, increasing the risk; generally it is better to swing than to scalp.

For example, in a bull trend, traders usually will trail the stop below the most recent higher-low after every new high. This usually means that the size of the risk is greater, which is typically the case when the probability is higher, as it is in strong trends. Whenever the risk is greater, traders should reduce the size of their trade so that the total dollars at risk are not greater than on any other trade.

In “One-way trading” (above), the market gapped up on the open and then had three consecutive bull trend bars up to bar 2. The bars had big bodies and small tails, and there was little overlap. This bull spike was a strong trend. The market went sideways for several bars, alerting traders that a weaker bull trend (channel) was likely to follow. The three bull bars up to bar 4 had smaller bodies and the tails were more prominent. Although this was another bull spike, it was weaker; it followed a small pullback to bar 3 and its loss of momentum made it a channel. Bar 7 was another pullback, this time a small triangle (the three pushes down were the bar after bar 5, the second bar after bar 6 and the bar before bar 7).

Because the channel up from bar 3 to bar 6 was tight (no pullbacks), shorting below bar 6 probably would be a losing approach. Once bar 7 formed (a bull reversal bar after the three pushes down), and because the selling only resulted in the market falling two ticks below bar 6, the bull trend was likely to resume. The market continued higher in another tight bull channel up to bar 10. When a channel is as tight as this, usually it is simply a spike on a higher time frame chart. Traders should not be looking for shorts.

The bear inside bar at bar 12 was after about 20 sideways bars and at the top of a trading range. Because the market had evolved into a trading range, traders would look to sell high. 

When buying in a strong bull channel, traders should shoot for a profit target at least twice as large as their initial risk, until the trend likely has ended and the market looks to be transitioning into a trading range. The market went sideways for about 15 bars after bar 10 and was therefore in a trading range. Many traders would have exited their longs below bar 12 because it was a bear bar at the top of a developing range. At that point, traders switched to trading-range trading. Some would have shorted below bar 12.

When swing trading in a bull trend, traders should consider putting their protective stops below the most recent higher-low. Because this often results in a bigger risk, traders need to reduce the size of the trade to make sure that the dollars at risk are no greater than on any other trade.

For example, for any long between bar 4 and bar 7 on “One-way trading,” the stop should be below bar 3. Once the market moved above the bar 6 high, traders would tighten their stops to below bar 7, the most recent higher-low. Some traders prefer to use a fixed number of ticks, such as two points, for their protective stops. However, the tighter the stop, the lower the probability of success. In strong trends, usually it is better to use a price action stop (below the most recent higher-low), even though the greater risk means that a trader would trade a smaller position.

Trends tend to weaken as they unfold. Traders can redraw the channel after each pullback and each reversal from a new high. The new channels tend to be flatter (with a shallower slope) and broader (with deeper pullbacks). Eventually, the pullbacks are deep enough that the channel has evolved into a trading range. Once there is a pullback below a bull trend line, lasting at least five to 10 bars, and reaches the moving average, traders begin to look for a major trend reversal. They want to see a test of the bull high and a reversal from there. As we can see in the chart, there was a lower-high major trend reversal below the bar 14 two-bar reversal. There then was a second entry short below the bar 15 double top for a swing down.

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