Channeling is one of the most reliable and accurate trading techniques that provide traders with precise entry and exit points as well as stop-losses and take-profit recommendations.
Channeling stock is a stock that moves up and down in repeated waves between two parallel lines. A lower line is called a support trendline and an upper – a resistance trendline. A support trendline connects the series of lows and resistance connects the highs. The area between these two lines is referred to as the channel. We need at least 4 dots (2 lows and 2 highs) to draw the channel. The more times the price touches and rebounds from the support and resistance lines without penetration, the more significant and reliable the channel becomes.
There are three types of channels:
- An ascending or a rising channel makes consecutive higher highs and higher lows.
- A descending or a falling channel makes consecutive lower highs and lower lows.
- A horizontal channel or a rectangle channel makes horizontal highs and lows.
Channeling offers several different efficient techniques for each type of channels. The most effective way of trading channel is to trade in the direction of the channel, going long at rising channel and shorting the falling channel. There are following basic rules of channel trading:
- Buy (or cover short position) at support level
- sell (or take a short position) at resistance level
Channel is considered “trade-able" if it consists of at least two lows and two highs.
Following is the real life example of how you can profit using this simple technique. Let’s look at the chart of QQQQ for the period from the January 2004. We can easily locate two relative highs: 38.54 in January 2004 (1/20/2004) and 40.33 in December (12/15/2004) and two relative lows: 32.52in August 2004 (8/13/2004) and 34.98 in April 2005 (4/29/2005). Now we are able to draw two trend lines – a resistance line connecting two highs and a support line connecting two lows. These lines are near parallel giving as a perfect channel. Following our basic trading rules we can place a buy order when the price crosses the support trend line and sell when the price crosses the resistance trend line. This simple technique will provide you with the perfect trading entry/exit points: sell on January 6, 2006 at 42.5 and buy on May 23, 2006 at 38.65.
There are several ways to locate the channeling stocks. You can manually look through charts or utilize the pattern recognition screener. Following links provide you with the list of channeling stocks and ETFs.
http://www.thegreedytrader.com/Risingchannelingstock.aspx
http://www.thegreedytrader.com/Fallingchannelingstock.aspx
To narrow your search you can use an advanced technical analysis filter to find a list of channeling stocks and ETFs with price testing the support or resistance line. For example, use the following links to find a list of equities with rising channel pattern with price near support level and equities with falling channel near resistance.
http://www.thegreedytrader.com/RisingChannelSupport.aspx
http://www.thegreedytrader.com/FallingChannelResistance.aspx
In addition to the basic trading rules a channeling technique provides risk management in form of stop-loss rules:
1. If you enter a long position at a channel support level, set a moving stop-loss slightly below the support.
2. If you open a short position at a channel resistance level, set a moving stop-loss slightly above the resistance.
There are additional trading rules and techniques that can help to improve performance and reduce the risk in case of the channel breakout, false breakout and channel narrowing.
Breakout appears when price breaks through the support or resistance line. You can tight protected stop-loss order to limit your risk. Some traders use channel breakout as a trend reversal confirmation to open a new position in the direction of the new trend. To estimate the minimum breakout target some chartists suggest measuring the vertical distance from the trendline to the latest high/low and projecting it from the breakpoint into the direction of the breakout.
In example with QQQQ above, if a trader opens a long position at channel support 38.65 on May 23, 2006 he immediately places a moving stop-loss order slightly below the support. When a price breaks the support line and a stop order is executed, a trader can also enter a short position to profit from the channel breakdown.
While a channel breakout terminates the current channel, the false breakout appears when a price just pierces the channel trendline and then moves back into the channel area. Usually a false breakout scares traders out of the stock and makes breakout traders enter the wrong position.
In opposite to the false breakout – the channel narrowing appears when price drifts inside the channel area without touching the support or resistance trendlines. In this case the narrower channel could be considered or other techniques can be used to enhance the accuracy.
There are several techniques you can use in conjunction with channeling to help verifying the channel strength, recognizing the price reversal and predicting breakouts.
- Overbought/oversold momentum oscillators and bullish/bearish divergence are useful for providing early warning signals of trend reversal.
- Candlestick patterns can be useful to confirm the price reversal or a channel breakout.
- Fibonacci technique is helpful in finding hidden channel cyclicity to spot an intermediate support/resistance within the channel area as well as for estimating the breakout target.
- Analyzing chart trends in several different time frames can also help you accurately determine the price reversal and a channel breakout.
- Channeling trend often presents an Elliot waves structure. The sub waves in the direction of a major trend have a five-waves impulse structure while sub waves in the opposite direction have corrective three-wave zigzag structure. Using Elliot Wave analysis with channeling stocks can provide a valuable trading strategy for an experienced trader.
Channeling works the best for short and medium-term trading with ETFs and medium volatility stocks. Channeling provides one of the most accurate and reliable market timing techniques especially when it is used in conjunction with other technical indicators.
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