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

Trading channels for profit

Changing priorities

In “Weak channel” (below), there was a strong bull spike up to bar 3, but then the market went sideways to bar 6. At that point, traders were uncertain whether the market was still in a weak, broad bull channel, forming higher highs and lows or in a trading range. It does not matter because traders should trade broad channels and trading ranges the same, looking to buy low, sell high and scalp.

Because there was a strong bull spike up to bar 3, the market was likely to have follow-through buying for many bars, probably in the form of a bull channel. Because a bull channel is still a bull trend, traders should pay particular attention to pullbacks and then look for longs. In weak bull channels and trading ranges, buy signal bars around the bottom of the channel often appear weak. 

As we can see in the chart, buying above bar 6 was a relatively easy long, but buying above bars 9 or 12 was less certain. Many traders would not have bought above bar 12, even though it was around the bottom of the channel, because it had a bear body and followed three strong bear bars. They might instead have waited for a second entry, especially one with a bull signal bar. Many would have bought above bar 13.

When scalping in a trading range or broad bull channel, traders should use a profit target that is about twice the size of their stop. However, if the setup looks strong enough to be confident that it will work, they can use a risk that is as large as their reward and still make money over time.

For example, a trader might use a two-point profit target and a two-point protective stop on all strong setups. Alternatively, a price-action stop may be used. If the trader bought above bar 9, the risk might be one tick below bar 9. The risk would be six ticks below the entry price. The trader might try to hold long for a reward that is twice as large as the risk, or about three points (12 ticks). As we can see in the chart, the market turned down at the bar 10 high, which was exactly 14 ticks above bar 9, and that is exactly where it had to go for traders to scalp out of their longs with 12 ticks of profit. This means that many traders did exactly that.

Shorting was more difficult in this channel. Some bears would have shorted below the bear reversal bar that formed three bars after bar 7, believing that the market was in a trading range and, therefore, that most breakout attempts would fail. (It was a reversal down from a high 2-buy setup and, therefore, a final flag reversal.) It was the third push up (bars 1 and 3 were the first two) and the market already had pullbacks lasting about five bars (bars 4 and 6).

The two-bar reversal at bar 10 was outside down, so traders were hesitant to short below its low. They might have been willing to look for shorts because it was around the top of the channel, and also it was a small wedge top with the two minor pushes up in the prior seven bars. Other traders would have waited for a second signal, such as shorting below the bear bar after bar 11. Some would have shorted on a limit order during bar 11 as it went above the high of the prior bar, expecting the market to form a second leg down from the wedge top, especially after the two strong bear bars down from bar 10.

Price-action trading remains one of the most direct forms of price analysis. Once you’ve become familiar with the various states of the market, it is a powerful and simple technique for exploiting moves in trends and channels.

 
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About the Author
Al Brooks

Al Brooks, M.D., is author of the Brooks Trading Course (27 hours of videos at BrooksTradingCourse.com), several books on Price action (Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader, Wiley, 2009, and the 500,000 word, three-book series, Trading Price Action, Wiley, 2012), and numerous articles in Futures Magazine. He also provides live intraday E-mini price action analysis and free end-of-day analysis on www.brookspriceaction.com.

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