- Channels are price ranges that a stock or other investment trades within over a period of time.
- The tops and bottoms of a channel can provide useful trading information.
- If stocks move sideways over the near term, there are several potentially significant price levels to consider keeping an eye on.
Just 2 weeks after breaking through to new all-time highs, US stocks—as measured by the S&P 500—are hovering near a potentially significant price level. The recent market pullback has brought back some short-term volatility, something investors have not had much of since mid-June. As the calendar turns to fall, investors may be wondering if the market can resume the rally, or if more uncertainty lies ahead.
Of interest to active investors who use chart analysis in their strategy, a chart of US stocks (included below) reveals that the market has not yet formed what chart users term a "channel." But if stocks keep trading in a range (i.e., move sideways) over the next several days and weeks, you may be able to use a few key price levels to help determine which direction stocks might go over the short term.
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 when a price moves between 2 parallel trend lines, regardless of the slope of those lines. More simply put, it's a price range that a stock or other investment trades within over a period of time. We'll focus primarily on sideways channels. 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, this price ranged 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" 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.
Building a channel
As the chart of the S&P 500 below shows, the February 2020 high was right around 3,380 (see The S&P 500 is grappling with an important price level chart). The COVID-19 outbreak sent stocks plunging below 2,250 earlier this year in record time, only to gradually recover all of those losses by mid-August. As the chart shows, the S&P 500 bumped up against the 3,380 price level a couple times in August before finally breaking through and climbing as high as 3,588.
After the recent pullback, 3,380 has once again served as resistance several times over the past 2 weeks. This price level may continue to act as a ceiling over the short term. But for a channel to form, there also needs to be a floor. You can see that 3,350 has acted as a short-term floor in recent days. However, it is unlikely to be viewed as a strong floor by chart users because there is a likelihood that it can be broken through, since that price represents such a narrow range from the current price and a potential ceiling price of 3,380.
From a charting perspective, it may be more possible to see a channel develop with the 3,380 price level as a floor and the all-time record high above 3,550 as the ceiling. It is also possible that 3,380 continues to act as a ceiling, and another near-term low—such as the June 3,000 price level—functions as a support level, if stocks drift lower from the current price range.
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 up and down recently. Rising volume can confirm an uptrend (or downtrend), and decreasing volume can fail to confirm a trend. Typically, volume tends to increase as summer turns to fall. While volume is up moderately from its nadir in mid-August, it is down from its near-term peak in early September. Consequently, this volume trend does not currently confirm any trend direction. But if the price does move in a particular direction, and volume continues to increase, that might support the evidence of a trend.
Trading within a channel
Some active investors use channels to trade more extensively. 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 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.
Given that it appears a channel has yet to fully form, without strong evidence for both ceiling and support levels, the S&P 500 would need to trade sideways for longer in order to generate a more powerful channel trading signal.
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 type of channel that chart users 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).
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. COVID-19 developments, along with economic and earnings growth—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.
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