Think of a price channel like a river. Similar to banks that contain water, a channel contains the price. We have ebbs and flows in price, just like the water weaving through a channel. Just look for the parallel lines that bind the stock‘s price to identify it on a chart. We see either a horizontal, ascending, or descending channel depending on which way the trend or water flows.
As a new trader, you will want to pay close attention to price channels. There are a few reasons, but the most important takeaway is this. A price channel helps you to identify two things: the direction of the price and the momentum.
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How to Use a Price Channel
- A price channel happens when the price of a security oscillates between two parallel lines.
- They can be horizontal, ascending, or descending.
- They help you to identify breakouts and breakdowns
- Sell when the price approaches the upper channel trendline
- But when the price tests the lower trendline of the channel.
Basics
Any and all. You can spot the channels in any instrument from futures to stocks, mutual funds and even exchange-traded funds.
In fact, you can look for wolfe waves as well. If you’ve been in our Futures trade room or regular room on Thursday’s then you know all above wolfe waves and channels.
The forces of supply and demand are the driving forces behind the formation of channels. As mentioned above, we see upward, downward, or sideways trending channels.
A stock in high demand creates a strong upward surge in price. Alternatively, you’ll see a steep descending channel in a stock experiencing a panic sell-off.
Sometimes, the price casually flows along without any push and pull momentum. As expected, price channels can happen during any time frame: 1-minute, 5-minute, or over 4 hours; it doesn’t matter.
Who Uses Them?
Pretty much any trader. Especially those who focus on the technicals or are looking for channels.
The price boundaries created by channels tell a trader when to enter and when to exit. You can use these for support and resistance.
And those are the most important levels to pay attention to. Stocks respect support and resistance so much it’s not even funny.
The forces of supply and demand are the driving forces behind the formation of channels. As mentioned above, we see upward, downward, or sideways trending channels.
A stock in high demand creates a strong upward surge in price. Alternatively, you’ll see a steep descending channel in a stock experiencing a panic sell-off.
Sometimes, the price casually flows along without any push and pull momentum. As expected, price channels can happen during any time frame: 1-minute, 5-minute, or over 4 hours; it doesn’t matter.
How to Draw Price Channels
Do you remember playing Connect the Dot games as a kid? I know I do, and it’s no different when drawing channels for price. At the point where the price pivots higher, draw the lower trendline. Similarly, when the price pivots lower, draw the upper trendline. What results is a channel, and the steepness determines the direction of the price.
Positive sloping trendlines bound an upward or ascending price channel. You can see this in picture #1 above.
This positive slope means the price is trending higher with each price change. It should be no surprise that a descending price channel has negatively sloping trendlines.
Thus, the price is trending downward with each price change. It’s not quite like forming triangles, however. So, you may not see any channels forming descending triangle patterns.
Price Channel Example
This is an example of a price channel in the ThinkorSwim platform. Notice that the two lines formed a rising wedge pattern with a temporary failure. The price continued to rise. Preceding the rising wedge pattern was a falling wedge pattern.
Support and Resistance Lines
If you haven’t figured it out yet, the two lines of a channel are support and resistance areas. And if you can identify them correctly, you can make money.
For starters, let’s look at the breakout. A breakout happens when the price breaches the upper or lower channel trendline.
As a trader, you spot a breakout by identifying an upward-trending channel. Next, you’ll see a volume surge and a trendline breakthrough.
Money can be made if you can spot a breakout in the making and enter at the right time.
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Trading the Price Channel
- Do you know when to trade within the channel?
- Sell when the price approaches the channel’s upper trendline
- Buy when it tests the channel’s lower trendline.
- Just take a look at the image below.
Conversely, there’s also money to be made in the downward channel. In the scenario above, you go long when the price breaks through the upper band.
However, in some cases, the price can’t break through the upper channel. Traders look to short the stock at the upper bound and take an even deeper short position once a breakdown is confirmed.
False Breakouts
A breakout doesn’t mean the price will continue in the direction you think it will. Sometimes, you could be seeing a false breakout. What is one to do?
For starters, you need to verify it is, in fact, a breakout. And this is where volume comes into play. We use volume to confirm uptrends like breakouts, downtrends, and overall chart patterns (i.e., head and shoulders, flags, cup and handle, etc.).
Final Thoughts
I must tell you a little secret about trading channels: Moving averages. From identifying support and resistance areas to the strength and direction of a trend, moving averages can help you in many ways.
For starters, a price far from the moving average indicates a weak trend. A weak trend means a potential reversal is on the horizon.
Equally important, the direction of the moving average reflects the stock’s price. A rising moving average means prices are rising.
Likewise, a falling moving average indicates prices, on average, are falling. A rising long-term moving average characterizes a long-term uptrend. Hence, a long-term downtrend is characterized by a falling long-term moving average.
