Channel trade

Here's what this technical indicator says about stocks now.

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Key takeaways

  • 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 be significant price levels for chart users.
  • Stocks have been trending higher for months, but chart users might keep an eye on a few key price levels to determine short-term market direction.

While stocks are down slightly from the all-time highs set in early September, the S&P 500 is still trading near 4,430—a roughly 20% total return gain (i.e., including dividends) year-to-date. Strong corporate earnings, historic government and central bank support, and expectations for additional government spending have helped drive the stock market to record levels.

But the risks of spending proposals not coming to fruition, on top of the Delta variant threatening to undo some business reopening progress, could stop stocks' momentum.

From a charting perspective, the market has not yet formed what technical analysts term a "channel." But if stocks form a trading 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.

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.

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.

Can channels help you trade?

The chart above illustrates the key aspect of channels: They 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) reveals that stocks have been in an uptrend for most of 2021, peaking in early September. Since then, stocks have retraced toward the August low. That low (around 4,390) could be a support level.

It’s worth noting that the recent price action may not qualify as a channel, according to chart users. While the price has touched support several times in recent weeks, it has not done so for the potential resistance level at the all-time high. Recall that stronger trading signals are sent by channels when support and resistance levels are touched multiple times and the price stays within the channel trading range. Also, note that volume is relatively low (compared with prior weeks). 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. Given the relatively low volume level, this is additional evidence that trading signals sent by support and resistance levels may not be particularly strong right now.

With that said, the S&P 500 has trended lower in recent trading sessions, and the next key test is the 4,390 support level. If stocks break below that level, that might be considered a short-term bearish signal. If stocks were to rally from this point and break above the all-time high, that would be considered a short-term bullish 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 it appears a channel has yet to fully form for the S&P 500 (due to weak evidence for a ceiling level), the S&P 500 would need to trade sideways for longer and establish a strong ceiling level 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.

Next steps to consider

Find new investing ideas and get up-to-the-minute market data.

Learn what you need to know before trading the market.

Learn about more technical indicators and how they can help you trade.

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