Trading Channels - Avant-Garde Investing

After you understand the basics of support and resistance trendlines, the next step is to become familiar with trading channels.

Forming a Trading Channel

A trading channel is formed by one support trendline and one resistance trendline. Assuming your lines are valid, securities tend to swing up and down within a channel, bouncing off the lines. Swing trading is a strategy used by investors who leverage the channel by entering positions at either the support or resistance level, and then exiting (or reversing) their positions at the next line. Think of this swing action like a pinball machine where you have a ball moving back and forth, bouncing off of one barrier and moving until it hits another.

Create a Perfect Trading Channel

In truth, perfection is impossible for humans. However, there are some effective tools and techniques that help you create channels that are as near-perfect as possible.

Creating trading channel using trendline duplication. — Here is an example where I have already drawn the upper resistance line in a particular channel on a 4-hour chart. I can tell by looking at the chart that this stock went through an extending upward-moving channel from the lower-left on the screen toward the upper-right.

To form a channel in the chart example above, you need to create a lower support line. You could manually draw another line using your trendline tool. However, standard channel lines typically run parallel to each other. This line correlation is a natural occurrence derived in part from the popular use of support and resistance levels using Fibonacci and other price-projection techniques.

To enhance channel accuracy, I suggest one of two approaches:

1) Use the “Duplicate Drawing” tool or something similar offered by your platform. By doing so, you create an exact match to your first manual line. Then, move that line into position where it touches points along the lower trendline.

2) Alternatively, some programs allow you to select a “Redraw as Channel” feature. This tool intuitively creates the corresponding trendline (support or resistance) to form your channel.

Extend Channels to Validate Lines and Project Swing Entries and Exits

As discussed in the post about support and resistance lines, every short-term line and channel is part of a longer-term line or channel. Charting platforms also allow you to “Extend” trendlines to the left or right.

In this same chart, I used the left-extension to test the historical accuracy of my lines. I place arrows at line touches so you can see how the trendline evolved. Remember the general rule that two points form a line and the third point that holds up validates the line as a useful trendline.

You can use the line-extension tools for a couple key purposes:

1) Test Historical Accuracy: Over the course of the life-span of a security, it is typical that the price action breaks out of a channel, but then at some point, returns to the channel. Channel re-entries occur due to the way in which broken support and resistance lines flip (support becomes resistance and resistance becomes support) after a breakout. In many cases, an initial attempt to break back into the channel is rejected at resistance. However, a follow-up test that breaks through the new resistance creates the re-entry. In an “Elite” post, I explain how this evolution leads to the head-and-shoulders or inverse head-and-shoulders pattern.

To test the accuracy of my trendlines, I use the left-extension feature. Doing so allows me to go farther back into the pattern history to see if the shorter-term channel lines are validated by other support and resistance levels. In most cases, you will find that they are, assuming accuracy. This validation enhances my comfort with relying on the newly created trendlines.

2) Project Forward: More importantly, identifying trendlines and channels as early as possible enables you to take advantage of low-risk, high-reward trading opportunities. Whereas a left-extension tests historical accuracy, a right-extension on your lines and channels projects future evolution. These projections are what create entry and exit opportunities with greater likelihood of success than someone who does not believe in or use technical analysis achieves.

In the example above, you can see how someone who identified the channel very early (after two initial line points were in place at support and resistance) could have taken advantage of multiple entry and exit opportunities with swing positions. The example below shows how someone could watch for an entry opportunity after the former support, now resistance line is broken. Another trading strategy, at this point, is to take a short position ahead of the broken support level. There are additional “futuristic” options that I explore in the aforementioned “Elite” post.

Here is the same 4-hour chart, with right line extensions used to project future channel opportunities. If the price is able to break the former support, now resistance line, it will re-enter the channel. At that point, it could break through the channel quickly, but is is more likely to extend out for a period of time equivalent to what you see on the left side. Then, a breakout up or down is likely.

Trading Channel Breakouts

Trading channel breakouts is another strategy, and often one with greater reward potential. There are two standard approaches to trading channel breakouts:

1) Enter the breakout point: One breakout strategy is to simply enter a position at the point where the price breaks through the support or resistance level of the channel. Utilizing Elliott Wave Theory is advantageous to identify potential points in time when this breakout could occur. In a conventional channel, there are at least 5 swing points before the next “swing” leads to a breakout. I get more into this topic in Elliott Wave Theory content.

2) Enter at the retest point: When a breakout occurs, it could develop as a “runaway break,” which means volume intensifies immediately and the price runs away from the point of the break. If you use the approach discussed in option #1, you can profit greatly. If you use strategy #2, you risk missing a strong move. However, a lot of traders get caught “chasing” a move because they do not use technical analysis, and instead, enter a trade based on momentum. A late entry on a breakout typically means you get caught “holding the bag” on a reversal and retest. Frustrated, many retail traders exit just before the retest of the channel break. With a retest entry, you wait until after the breakout stalls, and enter when the price returns to the break point and retests the newly-formed support. If the price holds, new traders enter, and the next move (Elliott Wave 3) is usually stronger and longer than the first.

Conclusions and Recommendations

You should now have a good understanding of how support and resistance trendlines are used to form trading channels. You should also know some of the more common options for trading within channel ranges, as well as trading channel breakouts. The strategies you use depend on your own assessment of risk and reward, and your strengths as an investor or trader.

After you have mastered the basics of trading, look for more advanced content on trendlines and channels with an “Elite” membership.