Channels are an important technical condition prevalent on almost all price charts on all time frames. Traders use these simple formations to identify profitable trade setups on both the long and short sides. If drawn and analyzed correctly, price channels can provide precise entry, exit, stop-loss and profit-taking levels for all types of traders in all markets. However, price channels have their limits, and those who put too much faith in them can get burned.

A price channel combines an existing trendline with a second, parallel trendline so that when the lines are taken together, they fully contain the price fluctuations in the current leg of the move. The upper trendline connects significant highs of the move, and the lower trendline connects the lows of the move. These trendline levels represent areas where key demand (support) and supply (resistance) exist. An asset’s price will oscillate between these levels — the upper and lower trendlines — helping traders position their entries and risk-aware exits.

All else equal, buy entries tend to be more profitable when placed at the lower end of the channel, and sell entries tend to be more profitable when placed at the upper end. Of course, that thinking assumes the channel will hold. Likewise, traders can set stop-loss and profit-target orders in the vicinity of these established highs and lows to protect the bottom line or get the most out of a position.

“Stepping higher” (above) shows a typical price channel in the S&P 500 stock index. After setting a low of 1266 on June 8, 2012, the S&P 500 generated a series of higher highs and higher lows — the classic definition of an uptrend. Although relatively short in duration, this is a typical example of how price trends play out, with surges and retracements that, when taken together, result in a net move in a predominant direction. What also is clear is that channels aren’t always picture perfect. Highs and lows are fluid, and traders must be alert and flexible as channels develop. 

Line drawings

Price channels are simply lines on a chart. They are easy to draw, but it’s important to approach the process in a systematic manner: 

• Identify a consecutive swing high and swing low pair. A swing price is simply a high (or low) that is surrounded by a defined number of lower highs (or higher lows) on either side. 
• If price is rising — it is in an uptrend — draw a line to the right off the swing high, connecting subsequent swing highs. This is the resistance line.
• Alternatively, if price is falling — it is in a downtrend — draw a line to the right off the swing low, connecting subsequent swing lows. This is the support line.
• After you have drawn the resistance or support line, draw a second line that connects the opposite extreme of the moves within the trend. Ideally, this line will be parallel to the resistance or support line that defines the rate of change for the move.

Like trendlines, the vast majority of channels rise or fall, identifying uptrends or downtrends. As you might expect, uptrend channels are considered bullish and downtrend channels are considered bearish.

A driving philosophy of channel trading is that the pattern of consistent highs and lows will persist. Per this assumption, buy when price nears the rising support line in an uptrend and book profits when price approaches the rising resistance line (see “On the up and up,” below). A common risk-management practice in this bullish scenario is to set a stop-loss order slightly below the support line. More risk-seeking traders also can trade against the trend — selling when price bounces off the resistance line in an uptrend or buying when prices reacts off the support line in a downtrend.

This trading strategy is simply flipped on its head for a downtrend channel. Sell when price nears the falling resistance line in the downtrend and liquidate the trade when price approaches the falling support line. The stop loss would be placed just above the resistance point at trade initiation. Risk-seeking traders also can elect to establish a long position at support. 

Channels don’t always rise or fall. They also can contain sideways moving markets (see “Swinging sideways,” below). Although advanced traders often will sell options during such periods to take advantage of the market’s reluctance to establish a defined trend, traditional traders should consider sitting on the sidelines as the opportunities for big moves are muted.

Rules to trade by

Although channel analysis helps investors take advantage of price oscillations, always remember this key rule: When the channel is broken, it’s done. Although there are certainly numerous cases of temporary violations of channel support and resistance levels, don’t assume this will happen. Betting against the break and being wrong can be quite costly. The channel can re-establish itself, of course, but make no assumptions. Wait for the swing highs and lows to re-develop and trade off them.

However, that doesn’t mean a break (up or down) in the trendline is not a trading opportunity. When the support line is broken in an uptrend or the resistance line is broken in a downtrend, it often signifies that the market’s expectation about the stock has changed. This break therefore can be used to generate a new bullish or bearish bias in the stock. 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 cases, the main trendline value should be used as the stop loss.

A break in the opposite channel line, on the other hand, indicates that the trend is becoming stronger. Traders might consider taking a fresh long position to participate in the initial euphoria that often follows such a break, or they can wait for a pullback and establish a new long at a more favorable price. In either case, keep in mind that breaks are typically volatile periods, and may be best left to nimble traders with seasoned risk-control techniques.

An early signal of a coming break might be given when prices fail to reach a channel line, turning in the middle of the channel’s width. Such return-line failure indicates that the channel is weakening and investors must be cautious with their trades when prices revisit the original trendline.

Channels also work well with complementary indicators. Moving averages, which depict the direction and extent of a trend, and oscillators, which can reveal intricacies of how quickly, slowly, strongly or weakly prices are moving within a channel, both are particularly helpful.

Channels are useful for short- to medium-term trading. They are not long-term trading tools. They also work particularly well on stocks with a medium amount of volatility. However, even long-term traders should be aware of channel formations. Any violation in this simple price pattern can foretell significant shifts in market sentiment and profit opportunities going forward. 

Bramesh Bhandari trades the Indian stock market and teaches technical analysis. Bramesh can be reached via email at bhandaribrahmesh@gmail.com.