From the April 2013 issue of Futures Magazine • Subscribe!

Between extremes: Trading with channels

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.

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