Trading Education

Flowing Channels

(This is the 15th in a series of articles on basic technical analysis originally published in Futures magazine.)

Traders often like to have some kind of well-defined idea of what prices “should” do – that is, if a price does this, then it should go there or it should stop going in that direction when it reaches X. That’s true for concepts such as support / resistance, retracements, Fibonacci numbers and several other trading techniques.

Perhaps that’s why some traders like using channels, which represent a flow of prices and the boundaries within which prices are likely to operate. The last article dealt with trendline channels or those channels based on a predominant trendline that is drawn straight across the bottoms or tops of a trending move and a channel line that is drawn parallel to the trendline. The channel that is formed contains most of the trading activity for the trend and is most helpful in longer-term analysis.

Channels are not limited to straight lines and can also be designed for short-term analysis. Perhaps the most common is based on a moving average of the close, which becomes the center of a channel or envelope, as shown on our July soybean chart using a 9-day moving average. The upper channel line in this case is 104% of the moving average, the lower channel line 96%. As with any moving average technique, you have a great deal of flexibility in selecting the type and length of the moving average and the distance of the channel lines from the average. You might also use the highs for the upper channel line and the lows for the lower channel line, for example, or an average based on some combination of open-high-low-close.

Whatever method you use, channels should contain almost all of the price activity for a market. If they do not, you need to adjust your channel parameters. A channel that is too narrow and has too many prices outside it will provide too many useless signals. A channel that is too wide may never give you helpful trading signals.

In general, the basic premise of the channel is that prices will tend to return to the center line. Here are some guidelines for trading with channels:

If the channel is relatively flat, buy as prices approach the bottom channel line and sell as prices approach the top channel line. A market in the lower half of the channel is priced below average value; a market in the upper half of the channel is priced above average value.
If the channel is sloping up, take only long positions, buying near the bottom channel line (or in the lower half of the channel) and exiting near the upper channel line.
If the channel is sloping down, take only short positions, selling near the upper channel line (or in the top half of the channel) and exiting near the lower channel line.
If a channel is rising steeply and prices are at the top of the channel in a bull market move, buy when prices return to the center moving average line.
If a channel is falling sharply and prices are at the bottom of the channel in a bear market situation, sell when prices return to the center moving average line.
If prices cross above the center moving average line into the upper half of the channel but do not move up to the upper channel line, it is a sign of a weakening market in which buying demand has dried up.
If prices cross below the center moving average line to the bottom half of the channel but do not drop to the bottom channel line, it suggests a market that is strengthening or that the selling pressure has diminished.

As with most aspects of technical analysis, channels should not be used alone but in conjunction with other indicators to arrive at a trading signal. Channels are only one way to reflect traders’ mass perception of a market; you may want to view it in several time frames. Occasionally, channel breakouts turn into home run moves, but experienced traders realize that markets tend to return to “normal” more often than not. Channels help you visualize what this “normal” is.

Next article: Market Bands
Previous article: Channeling Price Energy