Channels can help us decide which stocks or futures to trade and which to ignore. A channel, or an envelope, helps us determine when a market has reached an undervalued or overvalued level. It consists of two lines, one above and one below a moving average. When channel lines exist, prices often trend between the two parallel lines and it can be used for profits.
There are two main types of channels:
1) Straight envelopes- Straight channels or envelopes are better for traders of stocks and futures.Â They stay at a steady distance from a moving average, providing steadier price targets.
2) Standard deviation channels (Bollinger Bands)- The spread between the upper and lower lines constantly changes in response to volatility. When Bollinger bands are wide, there is high volatility. Likewise, when Bollinger bands are narrow, volatility is low.
In an uptrend, the upper channel line tends to touch the tops, while the bottoms seldom reach the lower channel line. In a downtrend, the lower channel line tends to touch the bottoms, while the tops seldom reach the upper channel line. In a flat market, both tops and bottoms tend to touch their channel lines.
A well-drawn channel contains approximately 95% of all prices for the past several months. When you draw out a channel, you adjust it so that only a few extremes are pointing out.
The longer the timeframe is, the wider the channel will be, which also means there is greater price volatility. In this way, weekly channels are likely to be twice as wide as daily channels.
Trading Techniques for Channels
1. Measure the channel - Before you enter in a trade, make sure you measure its channel because you want the swings to be wide enough so that you will have profit, especially if you have to pay for commissions and slippage. No matter how low the price is or how strong its technical pattern is, you must find a stock that has room to swing between the channel lines so that you can make a profit.
2. Trade near EMA - If we are bullish, we want to buy near the rising EMA and take profits near the upper channel line. This is in when the market becomes overvalued, which is at or above the upper channel line. If we are bearish, we want to go short near the falling EMA and take profits near the lower channel line. This is when the market becomes undervalued, which is at or below the lower channel line.
3. During Flat Moving Average - Go long at the lower channel line and short at the upper channel line. Take profits when prices goes back to the moving average.
4. Breaking of Channel Lines - Unlike the breaking of a major trendline, which indicates an important change in trend, the breaking of a channel line indicates an acceleration of the existing trend and usually travels a distance equal to the width of the channel.
5. Spotting a Weakening Trend - If prices fail to reach either side of the channel, it usually signals a weakening trend, an early warning of a reversal, and increases the odds that the other side of the channel will be broken too.
6. Spotting a Strengthening Trend - If prices move above a projected channel by a significant amount, it usually signals a strengthening trend.
To learn more about trade channels, read how to draw trend lines.