Price Channel (Continuation)

A price channel is a continuation pattern that slopes up or down and is bound by an upper and lower
trend line. The upper trend line marks resistance and the lower trend line marks support. Price
channels with negative slopes (down) are considered bearish and those with positive slopes (up)
bullish. For explanatory purposes, a “bullish price channel” will refer to a channel with positive
slope and a “bearish price channel” to a channel with negative slope.

1. Main Trend Line: It takes at least two points to draw the main trend line. This line sets the tone
for the trend and the slope. For a bullish price channel, the main trend line extends up and at
least two reaction lows are required to draw it. For a bearish price channel, the main trend line
extends down and at least two reaction highs are required to draw it.

2. Channel Line: The line drawn parallel to the main trend line is called the channel line. Ideally,
the channel line will be based off of two reaction highs or lows. However, after the main trend
line has been established, some analysts draw the parallel channel line using only one reaction
high or low. The channel line marks support in a bearish price channel and resistance in a
bullish price channel.

3. Bullish Price Channel: As long as prices advance and trade within the channel, the trend is
considered bullish. The first warning of a trend change occurs when prices fall short of channel
line resistance. A subsequent break below main trend line support would provide further
indication of a trend change. A break above channel line resistance would be bullish and
indicate an acceleration of the advance.
 4. Bearish Price Channel: As long as prices decline and trade within the channel, the trend is
considered bearish. The first warning of a trend change occurs when prices fail to reach
channel line support. A subsequent break above main trend line resistance would provide
further indication of a trend change. A break below channel line support would be bearish and
indicate an acceleration of the decline.

5. Scaling: Even though it is a matter of personal preference, trend lines seem to match reaction
highs and lows best when semi-log scales are used. Semi-log scales reflect price movements
in percentage terms. A move from 50 to 100 will appear the same distance as a move from 100
to 200.

In a bullish price channel, some traders look to buy when prices reach main trend line support.
Conversely, some traders look to sell (or short) when prices reach main trend line resistance in a
bearish price channel. As with most price patterns, other aspects of technical analysis should be
used to confirm signals.

Because technical analysis is just as much art as it is science, there is room for flexibility. Even
though exact trend line touches are ideal, it is up to each individual to judge the relevance and
placement of both the main trend line and the channel line. By that same token, a channel line that is
exactly parallel to the main trend line is ideal.

CSCO provides an example of an 11-month bullish price channel that developed in 1999.

 Main Trend Line: The January, February and March reaction lows formed the beginning of the
main trend line. Subsequent lows in April, May and August confirmed the main trend line.
 Channel Line: Once the main trend line was in place, the channel line beginning from the
January high was drawn. A visual assessment reveals that these trend lines look parallel. More
precise analysts may want to test the slope of each line, but a visual inspection is usually
enough to ensure the “essence” of the pattern.

 Bullish Price Channel: Subsequent touches along the main trend line offered good buying
opportunities in mid April, late May and mid August.

 The stock did not reach channel line resistance until July (red arrow) and this marked a
significant reaction high.

 The September high (blue arrow) fell short of channel line resistance, but only by a small
margin that was probably insignificant.

 The break above channel line resistance in Dec-99 marked an acceleration of the advance.
Some analysts might consider the stock overextended after this move, but the advance was
powerful and the trend never turned bearish. Price channels will not last forever, but the
underlying trend remains in place until proved otherwise.
Channel Characteristics
In the context of technical analysis, a channel is defined as the area between two
parallel trendlines and is often taken as a measure of a trading range. The upper trendline
connects price peaks (highs) or closes, and the lower trendline connects lows or closes. An
example of a channel is shown below. Breakout points in channels indicate bullish (on
upward trends) or bearish (on downward trends) signals.

Channels are useful for short-to medium-term trading - not long-term trading or investing.
The technique often works best on stocks with a medium amount of volatility. Remember,
the volatility determines your profit per trade. Channeling also tends to work best when the
technique is combined with other forms of technical analysis, at which we take a closer look
below.

Finding an Equity
Not all equities can utilize this technique as it requires that the underlying equity has an
existing channel in its chart. Generally, a channel consisting of four contact points is
necessary for the channel to be considered "tradeable." There are three ways to locate an
equity to which this strategy can be applied:

1. Manually look through charts to locate channel patterns.

2. Utilize software or a service that automatically recognizes channel patterns.
3. Subscribe to a company that provides you with a list of equities to which this
technique can be applied.

Creating a Channel
Channels are relatively easy to create using these four simple steps:

1. Locate a relative high and a relative low in the past from which to begin the channel.
2. Locate another subsequent high and low that follows one of the three following
patterns (see table below):
a. Ascending channel - higher high and higher low.
b. Descending channel - lower low and lower high.
c. Horizontal channel - horizontal highs and lows.

3. Draw two trend lines - one connecting the two highs, and one connecting the two
lows. Note that these two lines should be near parallel.
4. These two lines form your basic channel after there are at least two contact points
with the upper channel and two with the lower channel. More contact points enhance
the reliability of the channel.
Trading the Channel
Channels provide a clear, systematic way to trade. In fact, these simple instruments can
show you when to buy and sell, where to place your stop-loss and take-profit points, how to
determine the reliability of the trade and how long you should expect the trade to take! Let's
look at how these can be done.

Locating Buy and Sell Points

Channels help locate optimal buying and selling points. Here are the standard channel
trading rules:

 When the price hits the top of the channel, sell your existing position and/or take
a short position.
 When the price is in the middle of the channel, hold.
 When the price hits the bottom of the channel, add to your existing position, cover
your short and/or buy.

Two exceptions to these rules:

1.
1. If the price breaks through the top or bottom of the channel, then the channel
play ends until a new channel is established.
2. If the price drifts between the channels for a prolonged period of time, a new
narrower channel may be established.

There may be times when other forms of technical analysis are needed to enhance the
accuracy of the channel plays, and verify the overall strength of the channel. Using other
techniques in conjunction with channeling can also help you avoid the side effects of the
two exceptions listed above. A few useful ones to keep in mind are:

 Moving average convergence divergence - These can be used to confirm channel

movements, especially after a contact is made.
 Stochastics - These are useful to confirm channel movements.
  Volume - Analyzing volume ratios can also help you determine the strengths of
different channel movements, which determine the overall channel strength.
 Short-term moving averages - These can provide you with a short-term outlook on a
channel play. They are most useful after a contact is made to confirm the change in
direction.
 Candlestick patterns - These are useful for spotting channel breakouts.

Determining Stop-Loss and Take-Profit Levels

Channels provide built-in money-management capabilities in the form of stop-loss and take-
profit points. Here are the standard rules for determining these points:

 If you have bought at the bottom of the channel, set a (moving) take-profit point at
the top of the channel. Also, set a (moving) stop-loss point slightly below the bottom
of the channel, allowing room for regular volatility (taking the beta into
consideration).
 If you have taken a short position at the top of the channel, set a (moving) take-profit
point at the bottom of the channel. Also, set a (moving) stop-loss slightly above the
top of the channel, allowing room for regular volatility (taking the beta into
consideration).

Determining Trade Reliability

Channels provide the ability to determine how likely your trade is to be successful. This is
done through something known as confirmations. Confirmations represent the number of
times the price has rebounded from the top or bottom of the channel - in essence confirming
the accuracy of the channel. Here are the important confirmation levels to remember:

 1-2:Weak channel (non-tradeable).

 3-4: Adequate channel (tradeable).
 5-6: Strong channel (reliable).
 6+: Very strong channel (very reliable).

Estimating Trade Length

The amount of time a trade takes to reach a sell point from a buy point can also be
calculated using channels. This is done by recording the amount of time it has taken for
trades to execute in the past, then averaging the amount of time for the future. This strategy
relies on the theory that channel price movements tend to be nearly equal in time and price.

Conclusion
Channels provide one of the most accurate methods from which to trade in any market. By
"encasing" an equities price movement into two parallel trend lines, this simple chart can
provide the exact points from which to buy and sell, create stop-loss and take-profit points,
check channel strength and even estimate how long the trade will take. This technique is a
valuable asset to any trade