US stocks are up 18% in 2019 thus far, on a total return basis, driven in large part by a combination of persistent corporate earnings strength, share buybacks, a steadily maturing business cycle, uncertain monetary policy expectations, and the US-China trade dispute.
Looking at a year-to-date chart of US stocks (included below), the stock market appears to have been trading in a "channel," a term that chart users believe describes a price range between which the market (or individual stocks and other investments) may be trading over the past several months. Right now, stocks are near the upper end of this channel, and if they are able to break out to the upside, that would be a strong buy signal, based on this indicator.
Signals given by technical patterns—like channels—should never be used in isolation, which is to say that fundamental and economic factors are the core drivers of the market. However, if you like using chart patterns, including channels, they can help inform your market view so that you can optimize your strategy and potentially achieve better outcomes.
Obviously, stocks and other investments can go in 3 directions: up, down, or sideways. And even when a stock is moving sideways, it is eventually going up or down. This is why channel trading can be a useful tool; it can help you determine if a stock (or any other investment that can be charted) whose price is moving sideways might be poised to break up or down—setting up an opportunity to buy or sell.
What exactly is a channel? It's a price range that a stock or other investment trades within over a period of time. Generally speaking, there is no universally accepted time horizon or percent range that defines a channel. Instead, a channel can be loosely identified when an investment touches a high and low price several times, but does not move outside this range, over some period of time—typically no shorter than a few weeks or months.
Check out the chart below of a stock. Can you see the channel?
As the chart demonstrates, the stock traded between $67 and $70 during August. These 2 prices formed a range that chart users might identify as the top and bottom of a channel. You can compare this channel range with the prior months (when the stock was clearly moving up) and the months after the channel ended (when it was clearly moving down).
Here's a tip: Channels are easier to spot if they touch the same high price and the same low price several times over a certain period of time. The chart above is a good example: The stock essentially touched $70 twice and $67 four separate times, but never moved above or below those price levels while it was in the channel range.
Why are channels significant?
The chart above illustrates the key aspect of channels: They can reveal potentially important price levels, from a chart analysis perspective.
The 2 significant price levels for a channel are the "floor" and the "ceiling." The floor can be thought of as a support level because the stock may have a tendency not to fall below the floor price. The ceiling can be thought of as a resistance level because the stock may have a tendency not to rise above the ceiling price. Chart users attribute these signals to the psychology of individual investors attaching significance to price points that are perceived as important.
Also, a prior support/resistance level, once breached, may serve as a new resistance/support level (e.g., if a stock falls below a support level, that price can now be viewed as a resistance level, and vice versa).
Consequently, when a stock does break through the ceiling or the floor of a channel, chart users consider that to be a potentially noteworthy price move, and possibly the beginning of a new trend.
More specifically, if a stock price breaks through the ceiling of a channel and goes higher, this may be the beginning of a bullish move and might generate a buy signal. Alternatively, if a stock price breaks through the floor of a channel and goes lower, this may be the beginning of a bearish move and might generate a sell signal. These trading signals are the essence of a channel trading system.
Stocks may have built a channel
As the chart of the S&P 500 below demonstrates, a floor price within this current channel appears to have been set near 2,740. The S&P 500 has moved higher off this price 3 times this year: in February, March, and June. The chart also shows that a potential ceiling exists near 2,940. The S&P 500 repeled from that price in late April and early May, and it is worth noting that this ceiling represents the market’s all-time high as well.
The S&P 500 has been in an uptrend since early June, and is currently threatening to breach the ceiling of this channel. If stocks continue to rise, and the S&P 500 breaks above 2,940 (and holds above that price level), that would be considered a strong, bullish technical signal—particularly since this price level also represents the market’s all-time high.
As with other technical indicators, it is helpful to use any additional information the chart provides to evaluate the signals given by it. Notice how volume (as depicted on the bottom portion of the chart above) has been decreasing throughout June.
Rising volume along with the uptrend would be further confirmation of strength behind the uptrend. However, current conditions on the ground—such as lingering global trade disputes and uncertainty as to the Federal Reserve's next move—may be giving some investors pause, resulting in lower volume relative to prior months. Of course, this trend may also be due to a seasonal trend for volume to decline over the summer. Regardless, if stocks faltered and pushed below the floor price near 2,740, that would be considered a bearish technical signal.
Trading within a channel
Some active investors use channels more extensively. Not only can you use channels to generate trade signals when the price breaks above a ceiling or below a floor, you can also potentially trade a stock as it moves within the channel. For instance, if you spotted a channel forming between $40 and $50, you might consider placing buy orders when the stock neared $40 and placing sell orders when the stock neared $50. This is because these 2 prices levels may be technically significant as a floor and a ceiling.
Of course, this trading approach has unique risks, and if you did implement this strategy, you may also want to consider some risk management by placing stop/stop-limit orders at prices above and below the buy and sell prices, to help protect yourself against losses.
There is another point that is worth considering when assessing a channel. According to many technical analysts, the longer a stock remains in a channel, the more powerful the strength of a breakout is deemed to be. For example, if a stock were in a channel for 3 years and finally broke through a ceiling price, the strength of that bullish breakout might be considered more credible than if the stock had traded in the channel for only 3 months.
Channeling your inner trading power
If you spot a channel in an index or other financial security, it may be possible to enact strategies that take advantage of a range-bound market. For the active investor with a shorter-term outlook, you can look at a narrower time frame (i.e., weeks and months) to identify potential channels with ceilings and floors.
Another potentially attractive characteristic of channels is that they can be pliable. Even though sideways moves are the typical example of a channel, it is possible for channels to exist in moderate uptrends or moderate downtrends (see the chart below). In an uptrend, a rising channel might exist where the ceilings are gradually increasing (think vaulted ceilings), while the floors are also gradually increasing (like a ramp).
As you can see, it is possible to utilize channels in a number of different ways. When you are building out your trading strategy, consider channels as one way to get to your desired trading destination.