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How to Trade a Channel

How to Trade a Channel
April 24
22:38 2012

The Walkthrough

Here is a daily chart snapshot of Goldman Sachs (Symbol:GS) spanning from March 2011 to March 2012. The shaded areas are the afterhours market trading. This chart includes several technical indicators:

  • 8 period simple moving average (blue line)
  • 20 period simple moving average (red line)
  • 200 period simple moving average (green line)
  • Bollinger Bands (purple lines)
  • Relative Strength Index (RSI) (dotted line)
  • Volume (dark blue bars)

Ever wondered how to trade a channel? Or how exactly a channel is used? For new traders practice makes perfect. To get this practice, traders can use historical charts to better understand the strength or weakness of their particular style or new methods the trader plans to implement.

Historical charts give traders new areas of major support or resistance which will be important for intraday trades as these areas will present major pullbacks. In this example the focus will be to learn how to use Channels.

The channels on the chart above are represented by the two green lines that are running parallel to each other. The daily chart of Goldman Sachs shows a downtrend, as the market continues to fall a more accurate way of gauging this trend will be needed.

Most long term traders will use channels because the entry price is not as important as the overall trend of the market. Determining when this trend is over will be the sole purpose of this channel as the breaking of this channel will alert the trader to exit the trade.

More often than not the trader will see the price of the instrument test the channel. If the price stays within the channel then this is a signal that the trend is still strong and a trader can choose to remain in the trade. If the channel is broken then this is a sign that the trend is over and it is best that the trader exit the trade.

The trader is looking to see when the price or candles touch either side of the channel. Whenever the price touches the channel there should be a pullback to the center of the channel. If the channel is broken, this can be interpreted in 1 of 2 ways.

The channel may be too tight causing the trader to think the trend was broken, when in actuality the market just needed more room to trend.

Second, the trend is over and the price is due to breakout in the opposite direction. In the chart example above, the price touches the bottom part of the channel three times and then breaks above the 200 period simple moving average. Based on historical analysis, if the price stays above 122.00  the next area of resistance is 137.75.

The Lesson

Channels are a great tool for identifying the trend of a market and potential areas of support and resistance. It is important that the channel is not set too wide from the actual trend because this can cause the trader to stay in longer than expected. A tight channel lets the trader know as soon as the trend is over.


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