Trading in a channel

Stocks have broken out of a channel to reach new all-time highs.

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Until recently, stocks had been trading for more than a year in a “channel,” a term used by chart users to describe a price range between which the market (or individual stocks and other financial securities) may be trading. Then, in August, the S&P 500 broke through the top of this channel to hit new all-time highs. This may have suggested 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 be used to help inform your market view so that you can optimize your strategy and potentially achieve better outcomes.

Spotting channels

Stocks and other financial securities can go in three 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 such a useful tool; it can help you determine if an investment opportunity that is moving sideways might be poised to break up or down.

What exactly is a channel? It’s a price range that a stock (or other security) 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 hypothetical stock. Can you see the channel?

As the chart demonstrates, the stock traded between $67 and $70 during August. These two prices formed a range that chart users call 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 another important aspect of channels: They can reveal potentially important price levels, from a chart analysis perspective.

The two 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. 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.

Trading in a channel

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 bounces around 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 two 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 three 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 three months.

The S&P 500 broke out of a channel in August

As the multiyear chart of the S&P 500 shows below, U.S. stocks have extended the long-term uptrend that began in March 2009. There have been several relatively significant corrections, including most recently the short-lived decline during the June 2016 Brexit fallout. 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.

You might notice looking at the chart above that identifying the most recent channel between 1,850 and 2,120 may have helped investors identify a key support level from which stocks eventually rebounded. Recall that a helpful way to spot a channel forming is if the price hits a potential floor or ceiling multiple times. You can see how the S&P 500 fell near 1,850 in October 2014. They approached this price level again in September 2015, but did not fall below it. When the market hit a near-term low in February 2016, stocks did briefly fall below this support level, but rebounded quickly. This support level appeared to have held, suggesting that stocks might bounce higher.

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, 2,120 could act as a floor.

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. Additionally, channels can also be useful when used in combination with other chart analysis. If you’ve correctly identified a stock that is trading in a channel, it may enhance the usefulness of oscillators1—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 in the next room over), while the floors are also gradually increasing (well, this would just be a poorly built floor).

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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Technical analysis focuses on market action—specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you’re most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation.
Past performance is no guarantee of future results.
1. Oscillators are technical indicators that move within a band over time.
Views and opinions expressed may not reflect those of Fidelity Investments.
These comments should not be viewed as a recommendation for or against any particular security or trading strategy. Views and opinions are subject to change at any time based on market and other conditions.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
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