A trading channel is a chart pattern highlighted by two parallel lines bordering resistance and support within which a security trades during a period. Within a valid uptrend trading channel, an opportunity to buy into the uptrend is indicated by subsequent bounces up off the support level at the point where the price touches the support level at least twice.
The same is true for a downtrend trading channel where subsequent price movement shifts from the resistance level to the point where the price touches the resistance level at least twice to allow traders to sell.
A trading channel is drawn using parallel lines that follow the price floor (support) and price ceiling (resistance).
With a trading channel, smart traders sell stocks at the upper resistance line, hold stocks within the parallel trend lines, and buy stocks at the lower support lines.
Technical analysts rely on trading channels for information to guide both long-term analysis and trading decisions.
Understanding Trading Channels
Trading channels come in handy as they highlight support and resistance lines graphically. Technical traders often use trading channels to assess whether to purchase or sell their positions. Traders also use the channels to evaluate existing market volatility.
The upper resistance level in an uptrend trading channel marks the opportunity to sell stocks, while the downward support lines suggest an opportunity to buy securities. Using trading channels, technical analysts can track different patterns within a channel to identify short-term price movements and draw insights for long-term analysis and trading strategies.
A trading channel is identified using parallel trend lines and plotted on a security price series chart. Theoretically, traders believe that market prices will stay within a trading channel. They plan to buy at higher highs and sell at lower lows within the established trading channel. Although range trading is generally good for investors, a channel breakout occurs when a bigger opportunity presents itself.
Types of Trading Channels
1. Trend channel
In trend channels, the price series of a security shows the defined trend lines that slope at the support and resistance lines. Trend channels are not appealing to long-term traders since their entries represent clear counter-trend trades that cannot flow through reversals.
The activities of the trend channels depend on the trend cycle of securities. The trend cycles typically extend across exhaustion gaps, runaway gaps, and breakout gaps. Essentially, trend channels, when plotted on a graph, can either be ascending, flat, or descending.
2. Flat channel
The flat type of trend channel is formed when the slope of trendlines is zero. They are usually represented as a sideway market price movement without a downward or upward trend.
3. Ascending channel
The ascending type of trend channel is formed by two sloping parallel lines with a positive gradient at the support and resistance levels. The ascending channel exhibits a bullish trend when graphed on a price series chart.
4. Descending channel
The characteristics of a descending channel are two negative sloping trend lines at the point of support or resistance lines. As such, the trading channel exhibits a bearish trend.
5. Envelope channel
Envelope trading channels take longer-term price movements into consideration, making them useful to traders looking to extend their stay on the market. Trendlines used to draw envelope channels are statistically determined. Some of the most commonly used envelope channels are the Donchian Channel and Bollinger Bands.
6. Donchian Channel
The trendlines in Donchian channels are derived from high and low prices. At the same time, the high over a predetermined period (n) is used in drawing the resistance trendline.
On the other hand, the support line is derived from the security’s low over a predetermined period. Creating Donchian channels requires the use of various periods in which resistance and trendlines are referred after 21 days.
Indicators of a Trading Channel
In channel trading, when a stock’s price meets a resistance level, a trader will sell a long position, or alternatively, open a short position. The theoretical explanation behind the strategy is that a stock’s price will retrace back into the channel when it reaches the resistance level, and vice-versa when meeting a support level.
The trading strategy is followed only if the price does not break through above resistance or below support levels. If the price violates the conditions, it instead suggests a momentum trend or a breakout pattern is occurring.
Thus, the trading channel strategy is based on the notion that a stock’s price is expected to trade within a range. Due diligence is needed when using trend channels, given the possibility of breakouts occuring. Trend patterns are not always predictable in financial markets, making it difficult to always make maximum profits using this trading strategy.