Trading Price Channels
Price channels are chart patterns formed when the highs and lows of the candlesticks can be joined by an upper and lower trend line that are parallel to each other. They occur all the time in the market, but traders sometimes have trouble identifying them, which should really not be the case.
There are three varieties of price channels seen in the forex market:
a) ascending channels
b) descending channels
c) horizontal channels
Horizontal channels are the easiest of the three channels to recognize. Their boundaries can be formed by pivot points, which makes it easier for traders to visualize and identify. Horizontal channels occur when the market is moving sideways, or in a range-bound fashion. They define periods in which there is no clear trend. Horizontal channels typically form in the days preceding a major news release, as traders stay on the sidelines waiting for the news to give them trade direction.
Ascending channels form when the market is in an uptrend. The currency pair is trending upwards but as it does so, the price action rises and wanes. Even when this is happening, the market rises progressively. A snapshot of an ascending channel can be seen in the section on Trading the Channel Patterns below.
Descending channels form when the market is in a downtrend. The price action of the currency is seen to be trending downwards but as it does so, there are periods when the price of the asset falls and rises repeatedly, all within the confines of the two parallel lines that form the channel.
Trading the Channel Pattern
The first step in trading channels successfully is being able to identify them once they start to occur. In order to do this, the trader must use the price channel tool (or its equivalent) and apply it to the currency chart. The lines making up the channel are adjusted manually until they can join at least three points at which prices have made highs and lows together. Extreme care should be exercised in applying the price channel tool. The trader must not force the market to obey the lines he has drawn with the price channel tool, but should rather obey the price action in tracing the trend lines.
Once a good trace has been obtained, it is time to start shopping for trading signals. The signals are very clear: buy when the price is at the lower trend line, and sell when at the upper trend line. However, this simplified trade alert should only apply to a horizontal channel. In a rising market, selling at the upper trend line is a dangerous proposition, as well as buying at the lower trend line in a falling market.
There is a popular saying in the financial markets that “the trend is the trader’s friend until it ends”, so trading against the trend is not recommended. There is always the danger that the price could eventually breakout of its restraining trend line in the direction of the trend, countering any contrarian trades. So the way to go is to do the following:
– Ascending channel: buy on the price dips to the lower trend line. In the chart below, these regions are represented by the blue circles on the lower trend line.
– Descending channel: sell on the price rallies to the upper trend line. In the snapshot below, these regions are represented by the red circles on the upper trend line.
Sometimes, it is not just enough to buy on the dips and sell on the rallies. You need some form of confirmation for this signal, and this is where you can use your candlesticks. Candlesticks to be used are the bullish reversal candlesticks when buying, and the bearish reversal candles when selling. There will be lessons on bullish and bearish candlesticks in subsequent blog posts.