For much of 2018, US stocks appear 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.
Last month, the S&P 500 broke through the top of this channel to move back toward all-time highs. Chart analysts believe this pattern may suggest the beginning of a new uptrend.
Of course, 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.
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 an 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 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.
The S&P 500 broke out of a channel in July
As the 1-year chart of the S&P 500 below shows, US stocks have continued the more than 10-year bull market uptrend. However, there was significant volatility in the early part of 2018. After that, US stocks appeared to trade in a channel between 2,580 and 2,800 for the better part of 4 months.
Notice how the S&P 500 traded near the support level several times in March, April, and May, as well as near the resistance level several times in March, June, and July. In late July, the S&P 500 finally broke through the ceiling, and has remained above it since then. Chart users might interpret this as a bullish signal.
With stocks having recently broken through to new highs, the previous ceiling of the channel might now be considered a potentially significant support level. If stocks were to decline from their current price level, 2,800 could act as a floor.
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.
Additionally, channels can also be useful when used in combination with other chart analysis. If you've correctly identified a stock or other security that is trading in a channel, it may enhance the usefulness of oscillators—like RSI, MACD, or stochastics.* The reason is that oscillators, which are types of technical indicators, are considered most helpful for analyzing stocks that are trading in a range.
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.
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