The S&P 500 is up 11% thus far in 2023. Yet since touching a year-to-date high in late July, stocks have trended lower as oil prices have risen and the Fed has telegraphed another rate hike later this year. More recently, resumption of student loan payments and the latest government shutdown crisis have investors wondering if the arrow is pointing down for stocks.
So which way might stocks be headed? Based on a chart of US stocks, the S&P 500 may be in a channel that appears to be trending toward a support level (which could keep stocks from falling further). But if they were to break below that level, that would trigger a bearish signal.
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 something trades within over a period of time. It 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, although there is no specific time horizon or percent range that defines a channel.
How channels can help you trade
Channels can reveal potentially important price levels. 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.
A support/resistance level, once breached, may serve as a new resistance/support level (e.g., if a stock falls below a support level, that's a bearish move where 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.
It is also possible for channels to exist in uptrends or downtrends. 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).
What channel signals say about stocks now
Given that stocks have been mostly trending higher in 2023, it may be more useful to look at a rising trend channel.
September is historically the worst month for stocks, and this year has reflected that trend thus far. That has pushed stocks away from the top end of a rising channel resistance level. A chart of the S&P 500 (see below) reveals that stocks recently broke through the June low.
Stocks may be headed toward a key support level
Stocks appear to have hit a resistance level near 4,600 in early August and have since moved lower, trending down toward a support level near 4,200. If stocks were to bounce off this price point and move higher, that would be a bullish signal (because the floor of the channel served as support). If they were to break below this price level, that could be a bearish 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 this rising channel has been in place for a number of months, a break above resistance or below support could be deemed a strong channel trading signal.
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, the outcome of the government shutdown, and other market forces remain the most important factors that will dictate market direction. However, if you like using chart patterns, including channels, they can help inform your market view so that you can optimize your strategy.