One notable technical pattern that is more easily spotted in price action on the charts is the equidistant channel pattern. Formed by two parallel lines that trend upwards or downwards, the channel formation incorporates both trend following and breakout strategies in one single pattern. Traders that opt to trade the trend will be able to benefit from the emergence of a channel while contrarian traders can also utilize the pattern to spot reversal opportunities from breakout trades.
Basic Channel Properties
As the name implies, a channel is a path identified by two trend lines of equivalent distance apart from one another moving in the same direction and. The channel itself is typically confirmed by three points of contact on both the upper and lower lines of the channel. Aside from direction, the width of the channel is very telling of volatility. The wider the channel, the more volatile the price action versus a narrower channel which would be considered less volatile.
The distance between the lines is also relevant because it helps to determine how to properly set risk and reward conditions. When determining the reward potential, it is imperative to measure the distance between the channel lines and use this figure as the basis for calculating trade upside. Once identified there are two main strategies that can be employed: trend trading and breakout trading strategies.
Trend Trading Strategy
When trend trading, it is vital to stick with the trend and not fight the price action. In the case of an upward trending channel, long positions are suggested whereas a downward trending channel would be ripe for a short position. For upward trending channels, it is crucial to establish long positions near the lower channel line and not in the middle of the range with the upper channel line serving as the target. For a downward trending channel, short positions are to be established near the upper channel line with the lower channel line targeted.
It is especially vital not to trade contrary to the channel trend. For instance, in an upward trending channel, establishing a short position from the upper channel line targeting the lower channel line is not recommended, namely due to narrowing reward conditions compared to trend following positions. For the reverse scenario, long positions are not suggested at the lower channel line of a downward trending channel. Position risk remains constant while the reward side of the equation shrinks relative to the potential risk when trading a channel trend.
Breakout Trading Strategy
Unlike other breakout strategies such as range and triangle-based breakouts, channel-based breakouts are the most volatile, but offer the most attractive reward conditions. The key to identifying a breakout is waiting for a candlestick close above the upper channel line in a downward trending channel or below the lower channel line in an upward trending channel. Although breakouts can occur in the direction of the channel, experiencing accelerated directional momentum, this is not the traditional focus of channel breakouts.
Once a candlestick close outside the channel has been realized, the key is to establish a position in the same direction as the breakout as quickly as possible. Channel breakouts are typically confirmed by higher than normal transactional volume in the asset and accelerated momentum. Ideally, positions initiated near the channel line should have the reward set to 60-75% of the channel range. Even though a candlestick close is the first sign of a breakout, should prices slip back into the channel it is a strong indication that the move was a fake breakout and traders should patiently await for another break before getting involved in the trade.
Irrespective of using a trend following or breakout strategy to trade a channel, it is absolutely essential to understand how the distance between the channel lines is the basis for identifying the risk and reward conditions of any potential trade. Strong confirmation is also important for channels, and the three points of contact on both channel lines is the strongest sign the formation is real and set to continue.