From the April 2013 issue of Futures Magazine • Subscribe!

Between extremes: Trading with channels

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.

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