CO13 - Introduction to Channels

"Among the different methods of technical analysis, analyzing the markets using price channels is one way. The channels, as indicative by the name sits on the price chart and is drawn over price. They indicate the price action rather accurately as they tend to change direction. Understanding what price channels are and how they work is important. Using price channels, traders can get a different perspective of the markets. Typically, price channels are used in trend trading. This is because channel lines also tend to act as trend indicator. But the main difference is that depending on the price channel technical indicator that you are using, they can also plot the expected higher and lower boundaries of price. You can use price channels either by ready to use technical indicators, or you can also use technical drawing tools to plot the price channels manually. Read more about price channels and how you can use them in your trading."

Channels in technical analysis are two lines, upper and lower that engulf price action. Depending on the slope of the channel it can be either a bullish channel or a bearish channel.

Channels are somewhat similar to trend lines. However, when you chance the position of the channel, both the upper and the lower lines forming the channel can change. As the name suggests, channels are plotted on the price chart.

There are different types of channels. Some are based on technical indicators while the rest are based on technical drawing tools.

Channels based on technical indicators

In this subset of channels, the upper and lower boundary lines are plotted above or below the price chart. The slope of the channel depicts the trend which can be either bullish bearish of flat.

The most commonly used channels based on technical indicators are:

  • Envelopes
  • Bollinger Bands
  • Keltner bands
  • Donchian Channel

For the most part, channels based on technical indicators start with a moving average. For example, the Bollinger bands rely upon the 20-period moving average. Following this, the upper and lower bands are plotted two standard deviations away from the moving average.

Although the above examples of channel based indicators tend show the same information, the way those channels are constructed are somewhat different. For example, Bollinger bands measure the volatility of the price.

On the other hand, a channel indicator such as Donchian channels tends to plot the high and the low of the price for a certain lookback period.

The first chart below gives an example of the Bollinger band with the default settings of 20, 2.

CO13 01 Channel Indicator

Example of channel indicator, Bollinger bands

The concept applied to the channel indicator can vary depending on how it is being calculated. For example, with Bollinger bands, the bands tend to expand and contract, depicting the rise and fall in the volatility of price.

Similarly, if you would use the Donchian channel for example, it would plot the upper and lower lines depending on the lowest and the highest price for the past x periods of time. In this case, when price breaks out from the previous high or low price, a long or short position is taken.

Channels based on technical drawing tools

You can also plot channels based on technical drawing tools. In this aspect, the channels are plotted the same way as you would draw the horizontal support and resistance levels or the trend lines.

Within the various technical drawing tools, the most simplest of all channels is the equidistant channel. Using this indicator, you can connect two consecutive lower highs (for a downward sloping price channel) or two consecutive higher low (for an upward sloping price channel).

The final third point is connected to the opposite (low, or high) to form the price channel. The next chart below illustrates the use of the price channel.

CO13 02 Channel drawing tool

Example of price channel, Equidistant channel

In the above example we can see the downward sloping price channel. You can see that after initially plotting the price channel, price starts to breakout from this.

Similar to trend lines, price of the security can chance direction. It is important to note that price channels are identified only when price is nearing the end of the trend. Therefore, price channels via technical drawing tools are mostly used to identify a potential breakout from the price channel or a break in the trend.

Which of the two channels are better?

Price channels based on technical indicators or having to plot them manually have the same effect. But if you are a price action trader, then chances are that plotting the price channels manually is more effective.

But if you are struggling to plot the price channels, you can always start off with a price channel technical indicator. This can be a good way for you to understand the price action that is forming.

Unlike manual price channel drawing tools, with technical indicator based price channels, the channels are plotted continuously. Therefore, these channels tend to shift and change direction tracking the price action of the security.

Another aspect to bear in mind is that price channels act as dynamic support and resistance levels.

However, you should not trade them in isolation. It is always recommended that you make use of other technical indicators to complement the signals that you see from the price channel.

The main use of price channels is that they give a different perspective of the markets. Using channels you can analyze how far prices have moved away from the channel and this in turn can point you to potential trading opportunities.

Read 1041 times Last modified on Thursday, 04 July 2019 11:41