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Stocks in a channel

Here's what this chart pattern says about stocks.

Fidelity Active Investor
– 09/23/2022
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Key takeaways

Channels are price ranges that an investment trades within over a period of time.
The tops and bottoms of a channel can be significant price levels for chart users.
Stocks are approaching a channel support level, plus there are some other potentially key price points to keep an eye on.

US stocks are down 21% in 2022, due largely to the US central bank continuing to raise interest rates in an effort to curb inflation. After the September 21 rate hike by the Fed, the 2-year Treasury yield is near highs last seen in late 2007. But some signs of optimism for stock investors—namely lower gas prices signaling inflation may be slowing already—have helped markets stabilize in recent weeks.

From a charting perspective, it’s possible that the market has formed what can be called a "channel," where stocks appear to be moving sideways. Consequently, you may be able to use a few key price levels to help determine which direction stocks might go over the short term.

Spotting channels

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 for investors and traders that utilize charts; it can help you determine if a stock (or any other investment) whose price is moving sideways might be poised to break up or down—setting up an opportunity to buy or sell.

So, what exactly is a channel? Basically, it's when a price moves between 2 parallel trend lines. More simply put, 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 (or comes close to touching) 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.

Can channels help you trade?

Channels can reveal potentially important price levels due to the behavioral actions of investors and traders.

The 2 significant price levels for a channel are the "floor" or bottom price and the "ceiling" or top price. 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.

What channel signals say about stocks now

A chart of the S&P 500 (see below) shows that stocks have been declining for most of 2022, hitting a low in mid-June near 3,700. As inflation fears cooled down somewhat during the latter part of the summer, stocks rebounded, rising near 4,300. The S&P 500 has since fallen back near 3,900.

Chart users could interpret 4,300 as a resistance level, as it has served as a ceiling a few times over the past several months (twice in late April and early May, and then again in July). At the other end, a support level may be found near 3,780, given that the market bounced off that price a couple of times in late June and early July. Stocks have been trending lower in recent trading sessions, with the potential for this support level to be tested. Based on channel trading systems, a chart user might become bullish the closer the S&P 500 gets to 3,780, believing that it could act as a support level. Of course, a break below that support level would be interpreted as a sell signal.

Trading within a channel

Not only can you use channels to generate trade signals when the price breaks above a ceiling or below a floor, it is also possible to 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 involving market timing, which is exceedingly difficult for anyone. 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. It's important to know that stop orders do not guarantee execution at a particular price, and therefore do not necessarily provide protection against losses.

There is another point that is worth considering when assessing a channel. According to many chart 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 6 months 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 a few weeks.

Given that chart users may interpret the current price action as having formed a channel, a break above resistance or below support could be deemed a strong channel trading signal.

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 an 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 useful characteristic of channels is that they can be pliable. Even though sideways moves are the typical type of channel that chart users typically like to trade, 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).

Channeling your inner trading power

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. Earnings, central bank moves, supply chain developments, and other fundamental factors will continue to dictate market direction for the foreseeable future.

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. When you are building out your trading strategy, consider channels as one way to get to your desired trading destination.