When I began trading on the New York Commodities Exchanges, I cut my technical analysis teeth with point and figure charts.
After several days of drawing X’s and O’s on graph paper, I would roll out the several sheets of paper on the floor, (taped together), and hand draw trendlines.
From trendlines, I found parallels. These parallel lines drawn on graph paper became the foundation for one of the principal methodologies I use to find trades to this day. Only now, I use the drawing feature on my TradeStation Platform.
Channels can be used for any timeframe; intraday, daily, weekly, monthly and yearly. For this article, monthly channels as the longest timeframe I presently use, apply to longer-term trends.
What is a price channel?
A price channel is a continuation pattern that slopes up or down and is bound by an upper and lower trend line. The upper trend line marks resistance and the lower trend line marks support. Price channels with negative slopes (down) are considered bearish and those with positive slopes (up) bullish. For explanatory purposes, a “bearish price channel” is a channel with a negative slope. A “bullish price channel” is a channel with a positive slope.
To draw the channel lines, I took the extreme lows (you need at least 2 points), then created a parallel from that and dragged it up to the high points (the middle high or one of the critical points) of the channel top and drew a parallel line.
In the S&P 500 chart, I use candlesticks to represent prices. Each candle is one month of price action. The green candles are months that closed higher in price, the red candles are months that closed lower in price.
The thick black line is the 80-month moving average. That indicates the length of a typical business cycle that economists refer to.
The yellow line is the 23-month moving average or about a 2-year trend, that often measures corrections within the longer-term cycle.
The black parallel lines represent the channel.
After the 2001 dot.com bubble, the top black upper channel line you see going back before 2003 was the top of an older channel line, until the breakdown. Then, that line, violated, not only gave traders a great short-signal, but also remained useful as the top of the channel you see from 2002 until the peak high of 2007. A picture perfect technical signal, as the move to test the top of the channel was yet another short sell opportunity.
If traders missed the rally to short, they had another opportunity when the channel line broke down again in mid-2008.
On the monthly charts, or the timeframe I demonstrate here, the price remained below the bottom channel line from 2008 until mid-2013. Once the price traded above the the bottom of the channel, even those who missed the peak low in 2009, had a chance in 2013, to buy with a tight stop.
Notice that the price action remained within the channel from 2013 until 2017. Early 2017, the price busted out of what was by then, 15-years of channel top resistance. Hence, the price exploded.
To use channel lines when the price remains within them, look for a consolidation at either the low or high end of the channel. Then buy or sell the breakout or breakdown of that consolidation. In other words, we want tighter compression within the channel, closer to its bottom or top.
The wider the channel, the less velocity the break up or down is. Tight and narrow channels generally have more follow through. The more the energy is consolidated, the more forceful the breakout or breakdown is.
The Transportation (IYT) chart, is a high and wide channel. Similarly, to the SPY chart, IYT’s bottom channel line dates back to the 2001 breakdown when it was the top channel line.
Likewise, it touched the top of the channel in 2007-2008 for another short opportunity. And, it cleared back into the channel in 2013 for a buy opportunity.
Fast forward to 2017, although not as quickly as SPY did, once it cleared the top of the channel, up she went. As we head into 2018, we will look for a continuation of the move up and/or a breakdown below the channel top.
The U.S. Oil Fund chart has two clear channels. The first one dates to 2008. Once again, the price broke below the bottom of the channel offering a great short opportunity. Subsequently, that channel bottom became the channel top, which was so cleanly tested in 2011 before another huge sell-off.
After making new all-time lows in early 2016, I drew a new channel. The bottom of it connects the necessary 2 major points, the 2016 and the 2017 lows. The parallel drawn connects the highs of 2016 and 2017 (there are 3 points-even better!)
This new tight channel will offer traders a fabulous opportunity to either buy the breakout above or, if it pierces the top but fails to penetrate through it, a new short opportunity. Both scenarios will offer traders low risk with very clear stops to prevent big losses and huge potential for substantial gains.
In a high and wide channel, if the price breaks out from either the up or downside of the parallel lines and then proceeds to trade back into the channel, a trap is often set for the bulls or the bears.
Such is the case in the Real Estate ETF (IYR) chart. In July 2010 and 2011, the price of IYR fell below the bottom of the channel line signaling a short trade. However, both turned out to be bear traps. Looking at the price action in late 2011, early 2012, the price recaptured the bottom of the channel. A savvy trader could have bought it at $55.00 in late 2011 and risked to below $50.00 or the low of the green candle in mid-2011. That buy signal, with the return into the channel, yielded a gain of $20.00 or to $75.00, when the price tested but failed to clear the top of that channel.
I have huge eyes on this particular channel for 2018. Notice how well the price has been contained between the top and bottom of this channel that dates back nearly 10 years. Since a “bullish price channel” is a channel with a positive slope, the signal to watch for is a monthly close over the top line or around $91.00. IYR’s price peaked in 2007 at $94.99. Can you imagine how potentially explosive that would be should the price rise above the extended channel resistance and break out?
Conversely, should the price fall beneath around $75.00, the bottom of the channel, we could see a return in price to $50-60.00.
Channels are extremely reliable, and as illustrated, an excellent way to track continuing or emerging trends. However, the moving averages help you pinpoint the potential price action even further. In all the charts furnished, the trend continuation that has worked best is when the price is either above or below the 23 and 80-month moving averages.
More on moving averages in a future article.
For now, I wish you all a very prosperous 2018!