Identify and understand price channels
Price, or trading channels are a way to visualise trends and ranges on a chart and can indicate levels where the price is most likely going to reverse direction.
What is a price, or trading channel?
Whenever the price of an asset is trading within the boundaries of two trend lines for a prolonged period of time, it is said that the asset is trading within a channel.
A channel can be drawn by either two trend lines or by a channel tool within your charting software. Whichever method you choose to use, it is a manual process to put them onto your chart.
Identifying a price channel
When the price is in an uptrend, it is called an ascending channel.
When the price is in a downtrend, it is called a descending channel.
If the price is ranging within a horizontal support and resistance zone, it is called a horizontal channel.
If there is an uptrend or a downtrend, it means that you can usually draw a channel.
You need to draw two trend lines; one that connects two lows and one that connects two highs. It does not matter if two or more candles pierce through the trend lines, however most of the candles should be within the boundaries.
Why does price stay within a channel?
Channels are essentially a self-fulfilling prophecy and work because many traders have identified them and use them to trade. The more traders that identify a channel, the more the channel will be used to enter and exit trades.
To illustrate this, look at the image to the right, which represents an imaginary asset that has never been traded before – at the beginning, it is priced at $1. Everybody wants to buy it and so the price rises up to $4.5.
You can see in the chart that at the price of $4.5, buyers who bought at $1 may feel that they have made enough of a profit and start to sell. Now that these traders are selling, there is more supply than demand for that asset and the price starts to fall. To secure their profit and avoid losing more in the sudden downtrend, more and more people start to sell and the price falls to, say, $2.
At this price, traders may think that the asset might be cheap again, because they are aware that the asset previously reached $4.5, and so they start buying again.
As soon as the price of the asset reaches $5, traders may decide that the price of the asset is too high, because it previously sold off at $4.5. To secure their profit, they start selling; the price will start to fall again under the new selling pressure. When the asset reaches $2.5, this becomes cheap in comparison to $5 and so traders start buying again.
Traders can now see this price action — the zigzag of the price action shown on the chart. In the image to the right, the zigzag of price action produces the highs number_1 and the lows number_2 and traders use these to draw trend lines; hence the channel is born. A channel can be traded for some time until the fundamentals change and the price breaks out of the channel, which then makes the channel invalid.
Using channels in trading decisions
The easiest way to use a channel for trading is to presume that the asset will stay within the boundaries. You then take a short trade whenever the price touches the upper boundary and a long trade at the lower boundary.
In the chart below, price ranges within the ascending trend lines and forms an ascending channel, thus creating buy and sell opportunities.
- Potential sell opportunities
- Potential buy opportunities
Another way to use channels in trading is to trade breakouts. In this case, as soon as a candle opens and closes outside the channel, you will take a trade: a long trade when the upper boundary is broken and a short trade when the lower boundary is broken.
In the chart below, the price breaks through the channel to the downside and closes on the outside — this creates a potential sell opportunity.
- Price breaks through the channel and closes outside
Price channels are very powerful and traders adhere to them. This means that when the price breaks out of a channel, many of these breakouts could be false. In order to avoid a false breakout, wait for the candle to close outside of the channel before entering, or even wait for a re-test of the trend line.
Using channels in multiple time frame analysis
The third possibility when trading channels is to use them as guidance in multiple time frame analysis. This means that if the asset is trading around the upper boundary on a higher time frame, you can enter short trades on the lower time frames with a tighter stop loss. Likewise, you can enter long trades on a lower time frame when the price is near the lower boundary on the higher time frame.
In the chart below, the channel is confirmed on a higher time frame.
- Swing highs and lows confirming the channel
- Potential trade opportunities – see below
In the following chart, the same channel is used on a lower time frame to more accurately identify potential buy and sell entry points.
- Potential buy entry at the lower boundary of the channel
- Potential sell entry at the upper boundary of the channel
So far, you have learned that:
- a price channel can be identified whenever the price is trading between two boundaries.
- there are three types of channels, an ascending channel found in and up trend, a descending channel found in a down trend and a horizontal channels when the price is moving in a range.
- when a channel is identified, more and more traders use them and so they become a self-fulfilling prophecy.
- you can find short trades when price touches the upper boundary and you can long short trades when price touches the lower boundary.
- you can also use the break out of a channel to find trades.
- you can use channels with multiple time frame analysis to find low risk entries.