Trading or Price Channels in Technical Analysis [Trading Guide]

Written by Navdeep Singh in Technical Analysis Q&A

Trading Channel, or a Price Channel, is a trading tool that technical traders use to identify opportune moments for entering and exiting trades in Technical Analysis. Incorporating Channels into your trading strategy is one of the easiest and most efficient ways to make some considerable profit in capital markets. But what exactly are these channels, and how can you leverage them in trading? 

A Trading Channel, also known as a Price Channel, is a tool used for identifying trading ranges in technical analysis. It consists of two trend lines that set upper and lower boundaries, which describe the range-bound movement of price over a prolonged period within the limits set by these boundaries. 

The two lines that form the boundaries of the price channel are supposed to be parallel to each other and serve as support and resistance levels for traders’ reference. In the remainder of this article, we’ll discuss the trading/price channels in more detail, including their types, methods to identify them, their interpretations, and a few strategies that you can employ to trade using them. 

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Types of Trading or Price Channels

In Technical Analysis, there are three notable kinds of Trading or Price channels that are named based on their orientation. These are – 

  • Ascending Channel – An Ascending Channel tracks the movement of the price while it is in an uptrend. Visually, it consists of trendlines that slope upward from left to right.
  • Descending Channel – A Descending Channel tracks the movement of the price while it is in a downtrend. Visually, a Descending Channel will have trend lines that slope downward from left to right.
  • Horizontal / Flat Channel – When the movement of price over time is horizontal, there is neither an uptrend nor a downtrend. In such situations, a flat channel will be formed with trend lines that flow straight from left to right without sloping upwards or downwards.

In each of the above-described channel types, the lower band serves as a support line, and the upper band serves as a resistance line. Hence, when using these channels in your trading strategy, these levels can be leveraged to evaluate a buy or a sell setup on the price chart of various securities. Additionally, these levels can also be used to forecast the future movement of price based on its current position with respect to the channel, and can therefore prove very valuable in trading. (This concept is covered and explained in-depth in the trading section of this article.)

Finally, it is essential to note that the insights that all three of these channel types provide are similar and the way their upper and lower bands are interpreted remains the same. Therefore, irrespective of the channel type, the trading strategies that you can employ to trade channels remain the same. 

Other Variations of Trading or Price Channel 

Before we move to the next section, it is also important to discuss two other variations of channels that you can leverage to make trading decisions. In essence, strategies to trade these two channel variations are no different from the three channel types discussed above, however, there are considerable differences in how these channel variations are calculated. 

These two additional variations of Trading Channels, or Price Channels, are as follows –

  • Envelope Channels
  • Fibonacci Channels

Now, let us briefly discuss both these channel variations.  

Envelope Channels 

The Trading Channels, indicating price range over a specified period of time, that are created with the use of various Envelope Chart Indicators are referred to as Envelope Channels. These channels comprise a central line, which is generally calculated using a variation of moving average, an Upper Band, and a Lower Band. In these channels, similar to the three channel types discussed above, the Upper and the Lower Band of these channels serve the purpose of resistance and support respectively.  

Different Envelope Indicators employ different calculations to calculate the Upper Band, the Lower Band, and the Central Line. The Bollinger Bands Indicator, which is one of the most widely used technical indicators generating an Envelope Channel, uses Simple Moving Average (SMA) to calculate the Central Line, and under default indicator settings, plots the Upper Band and the Lower Band at a distance of two standard deviations of price movement ABOVE and BELOW the Central Line respectively.    

Popular examples of other technical indicators that can be used to generate Envelope Channels include Donchian Channels, Keltner Channels, etc.

Fibonacci Channels

Fibonacci Channels is another variation of the Trading or Price Channels. In the case of Fibonacci Channels, the upper and lower boundaries are based on Fibonacci numbers. In essence, Fibonacci Channels are constructed from Fibonacci Retracement levels, which are horizontal lines that appear on a price chart of a security, indicating price levels at which support and resistance zones are likely to occur. 

In naming these channels, the “Fibonacci” part alludes to numbers that make up a sequence where each percentage is based on the division of the two consecutive Fibonacci numbers: 23.6%, 38.2%, 61.8%, and 78.6%. The idea with forming the channels here is that the movement in price can be assertively identified after the 5th wave of price movement in an up and down cycle.

Identifying Trading or Price Channels

Even though the concept behind recognizing the Trading or Price Channels is relatively simple, it is not uncommon for traders to draw a channel on the price chart when it does not exist. Therefore, in this section, we will discuss a few pointers to correctly identify and draw Trading Channels.

In essence, correctly identifying and drawing a Trading Channels involves mastery of two concepts. These are –

  1. Understanding the construction rules of Trading or Price Channels
  2. Identifying Trading or Price Channels using Technical Indicators and Tools 

Now, without further ado, let us briefly discuss both these topics so that you can correctly identify channels on the price chart of any security. 

Trading or Price Channel Construction Rules

When incorporating Pricing Channels into your overall trading strategy, it is important to be mindful of several rules for constructing or drawing, these channels. 

In summary, there are four construction rules that you must follow when trading channels. These are –   

  1. The Upper Band of the channel must be formed by connecting points that mark out the highest price points over a period with the help of a trendline.  
  2. Similarly, the Lower Band of the channel is a trendline formed by connecting points that mark out the lowest price points over a period.
  3. The two trendlines, the Upper Band and the Lower Band, that form the channel should run near parallel to each other. 
  4. You will need at least two lows and two highs to create a true channel that can facilitate trading decisions. The higher the number of extreme price points in creating a channel, the higher will be its accuracy and reliability. 

NOTE: The above-stated rules only apply to regular channel types, namely – the Ascending, the Descending, and the Flat/Horizontal Channels. The construction of Envelope Channels and the Fibonacci Channels is governed by a separate set of rules that are beyond the scope of this article. 

Identifying Trading or Price Channels using Technical Indicators and Tools

Now that we have established the set of rules that govern the construction of a Trading or Price Channel, let us now review several technical indicators and tools that can help you with identifying these channels.

Listed below are examples of several technical indicators and tools that can be used for identifying a price channel –

  1. Japanese Candlesticks
  2. Moving Averages
  3. Bollinger Bands
  4. Fibonacci Channel Indicator

In the following sections, we will discuss how you can use these indicators/tools to correctly identify the Trading or Price Channels.

Japanese Candlesticks

Candlesticks are graphical tools that appear on trading charts, and quickly show the performance of the stock—including its high, low, opening, and closing prices—over a selected period of time. If you are looking at a monthly candlestick chart, for example, every individual candlestick will indicate the highest, the lowest, the opening, and the closing price of the security over a month’s timeframe.

As we discussed earlier, the Upper and the Lower bands of the Price Channel are formed by connecting the subsequent highs and lows respectively. With Japanese Candlesticks, visually it becomes really easy to decipher the highs and the lows over your selected timeframe. The shadows or “wicks” above and below the candlesticks mark these price highs and lows, respectively. 

Moving Averages

Moving Averages give a smoothed-out description of the average price over some time. In the case of envelope channels, they are often used, either directly or indirectly, to calculate the upper and lower bands of the channel. 

But even in the generic sense, Moving Averages can be coupled with the bands to confirm the pattern of price movement. Directionally, the Moving Average line should run near parallel to the Upper and the Lower Bands of a correctly constructed channel. Hence, you can leverage a Moving Average line to confirm the accuracy of an identified Trading Channel. 

Bollinger Bands

The Bollinger Bands indicator is one of the most widely used technical indicators that can be used to generate Envelope Channels. As described above, it uses a Simple Moving Average (SMA) to calculate the Central Line, and in its calculations, the Upper Band and the Lower Band are plotted at a distance of two standard deviations of price movement from the Central Line.

In comparison to several other Envelop Channel indicators, Bollinger Bands are quick to react to rapid fluctuations in the price of a security. For this reason, Bollinger Bands are great for the short term trading of more volatile assets.

Fibonacci Channel Indicator

Unlike the construction of regular channel types (i.e. the Ascending, the Descending, and the Flat/Horizontal Channels) that simply requires you to connect the consecutive highs and lows in the price of a security, the construction of Fibonacci Channels involves a series of calculations. Even though it is possible to handle these calculations manually, doing that might be a bit taxing and an inefficient use of your time. Hence, you can leverage a Fibonacci Channel Indicator to address this issue. Most charting platforms provide you with this indicator for free and it will automate all the calculations, and hence the construction of the Fibonacci Channels, for you. 

Interpreting Trading or Price Channels

In order to correctly interpret the Trading or Price Channels, you need to first understand the psychology within the market that creates them. 

There are three groups of traders that participate in the market at any given price level. These groups are –

  1. Bullish Traders: These are the traders that are inclined towards going long and anticipate to profit from an increase in the price of the security.  
  2. Bearish Traders: These are the traders that are inclined towards going short and hope to profit from a fall in the price of the security.
  3. Unbiased Traders: This is the group of traders that are not biased towards trading in either direction and will trade in the direction implied by the market.

Now that we have established the three groups of traders that participate in capital markets, let us now discuss the market psychology that creates a Trading or Price Channel using the concept of Momentum Investing. 

Momentum Investing

Momentum Investing is a psychological event that can cause the price of an asset to rise to a peak and then fall again. Some investors will purchase a security in anticipation of its price increases in the near future. These investors that are bullish on the security are the Bullish Traders described in the previous section. Others, or Bearish Traders, will short-sell the same security in anticipation of the price hitting a peak at which the uptrend will reverse.

In essence, it is the constant battle between both these groups, the Bullish Traders and the Bearish Traders, that lead to the development of Trading or Price Channels. Unbiased Traders, with their short term trading activity, simply add to the momentum of the price movement in the winning direction.  

During an Uptrend, it is the Bullish Traders that have control over the market for the security being traded, and the Unbiased traders side with them, adding to the momentum of price increase. As the price of the security rises higher and higher, both Unbiased Traders and Bullish Traders begin to lose interest in the security and start booking profits on their trades or investments. It is at this stage that the control of the market is gradually attained by the Bearish Traders, resulting in the formation of a downtrend.   

During a downtrend, traders sell and short-sell more aggressively. Many traders who still own the security do not want to make losses and scramble to sell their buys before they incur more losses. The influx of supply and the decrease in demand causes the price to fall further. Beyond this stage, the only individuals making purchases are from a group known as “bottom pickers.”

Bottom pickers, as they are called, are the most Bullish of the Bullish Traders. These are individuals who will purchase the stock when all panicky sales have been made. This is usually near the lower band of the channel. Bottom Pickers understand that at this point, there is no one left to sell. Anyone who has not sold does not intend to. So, the market will have to bounce back upward, at which a bottom picker will profit from price increases.

Hence, as you would note, this constant battle between the Bearish and the Bullish Traders results in a constant fluctuation of price between the levels of extreme demand and supply for the security. When these supply and demand zones are marked on the price chart of a security, a Trading or Price Channel is formed, with its Upper Channel and Lower Channel indicating the Supply and Demand zones for the security. 

Improving Reliability of Channels in Trading

Trading or Price Channels have long been counted amongst some of the most reliable trading concepts within the realm of technical trading. That being said, similar to any other tool/concept in technical analysis, channels do come with their own set of limitations. Three shortcomings that you need to overcome when trading with a channel are as follows –

  • Trading or Price Channels are based on historical price movement. Even though the channels indicate price points at which it is important to watch out for reversals, they provide no insights on the likelihood of a reversal happening at these levels. Hence, you can rarely rely on trading signals that are solely based on Price Channels.
  • The predictive power of channels can dramatically drop when the price violates the integrity of the Upper and the Lower channels. In other words, once price moves beyond the Upper or the Lowe channel, the limits set by the price channel are no longer as effective as they originally were in predictive reversals.
  • The Price Channels offer information on the directional movement of the price, but not on the trading volume, which is another critical aspect of technical analysis. Without any indication of trading volume, it is hard to forecast the momentum of the price movement post reversal. Since, Volume and Momentum are important parameters for entering trades for most technical traders, relying on Trading or Price Channels alone will not be sufficient for a majority of technical traders. 

Given these above-stated limitations, it is advisable that you combine trading signals from Price Channels with other complementary tools in technical analysis to improve their reliability in trading. 

Several indicators that are known to work well in improving the reliability of trades taken with Trading or Price Channels are as follows:  

  1. MACD (Moving Average Convergence Divergence): MACD, when coupled with a price channel, can help tackle the first limitation discussed above. MACD is a momentum indicator that can be used to gauge the strength and the weakness of a trend. Additionally, with the help of MACD, you can measure divergence on the price chart of a security, thereby gaining additional insights on the likelihood of an upcoming reversal. In light of these additional insights that the MACD provides, it complements the trading signals from Price Channels very well, thus improving their reliability.  
  1. Fibonacci Retracement and Extension Levels: In technical analysis, Fibonacci Retracements and Extensions are counted among the strongest indicators of potential trend reversal zones. The reliability of reversal signals from the trading channels gets considerably amplified when it coincides with an important Fibonacci level. Hence, the second limitation of the channels discussed above can be compensated by confirming trading signals from Price Channels using a Fibonacci Retracement and Extension indicator.
  1. On-Balance Volume (OBV): The On-Balance Volume (OBV) is a popular indicator that is used to measure the trading volume. Hence, by adding this indicator to your Price Channel trading strategy, you can compensate for the third limitation of the channels indicated above.

Trading Strategies: Trading or Price Channels

Identifying Trading or Price Channels on the price chart of a security is not the most complex part of trading them. The real challenge is to identify high success probability trades using them in real-time. Hence, to profit from trading these channels, it is important for you to have a few trading strategies up your sleeve. 

With Trading or Price Channels, there are two simple trading strategies that can be used to identify trading opportunities that have a high probability of success. These are – 

  1. The Pullback Trading Strategy
  2. The Breakout Trading Strategy  

Now, without further ado, let us discuss both these strategies in a bit more detail. 

Trading Strategy 1: Pullback Trading Strategy 

In the Pullback Trading Strategy, as its name implies, trading decisions are made based on the assumption that after the price touches either the Support or the Resistance (the Lower or the Upper band), it will pull back and move in the opposite direction. 

There are three main stages to trade using the Pullback Trading Strategy. These are –

  • Determining Trade Entry
  • Determining Stop-Loss Target
  • Determining Take-Profit Target

Now, let us discuss a few important pointers for each of these three stages that you can use to your advantage when trading using this strategy. 

Determining Trade Entry

Identifying Pullback Trades is not very complex once you have correctly identified the Trading or Price Channel. Once you have two consecutive swing highs and two consecutive swing lows on the price chart of the security that you are trading, your channel has been established. After this point, trading decisions can be made. 

It is also important to note that for the price structure to be called a true Trading or Price Channel, the Support and the Resistance line forming it must be near parallel with respect to each other. After you have confirmed that the chart structure that you are looking at is indeed a true channel, you can leverage the below-stated guidelines to enter a Bullish and a Bearing trade using it. 

  • Bullish Trade: Purchase the security that you are trading when its price is at a low point, near the Lower Band (or Support Level), and just before it pulls back. At this point, we predict that everyone wanting to sell, or short sell, has already made a transaction. Therefore, at this point, the market should be near its lower limit, and set to go back to an uptrend. If the price should rise, the trader who made this transaction will profit from buying at a low price and selling at a high one.
  • Bearish Trade: Sell or short sell the security that you are trading when the price is at its high point, near the Upper Band (or Resistance Level), just before it pulls back. You do this with the prediction that price will revert to a downtrend. If the price should follow this prediction, and the trader has shorted some shares, they will benefit from borrowing shares at a high price and returning them at a low price.

The strength and the reliability of these above-mentioned trade entries can be further enhanced using the MACD. 

For confirming a Bullish Trade using MACD, you look for the shorter moving average to be above the longer one, as this indicates a bullish market developing. Similarly, for confirming a Bearish Trade, look for the shorter moving average to be below the longer moving average because this means a bearish market is evolving.

NOTE: Even though this section described Pullback Trade entries with a focus on regular channel types (i.e. Ascending, Descending, or Flat/Horizontal Channels), the same principles can be applied to trading an Envelope or Fibonacci Channels as well. 

Determining Stop Loss Target

With the Pullback Trading Strategy, you will set your stop-loss target to prevent losses in case the price does not pull back in the opposite direction, and it ends up breaking out from the channel instead.

Below is how you should think about setting the stop-loss target when taking a Pullback Trade – 

  • Bullish Trade: Set the stop loss for your trade just a few points below the Lower Band (or Support Level). In doing so, the assumption is that if the price falls below this point, a bearish breakout is likely.  
  • Bearish Trade: Set your stop loss for a just point just above the Upper Band (or Resistance Level). Just as with setting stop loss for a bearish trade, in doing so, you are assuming that if the price rises above this point, a bullish breakout is likely. 

If a breakout occurs, it implies that the range is broken and that the price may not pull back. In such situations, continuing to trade on a pullback strategy would prove costly. Therefore, exit if a breakout occurs and try a different trading strategy to profit from that movement in the market.

Determining Take Profit Targets

When taking a Pullback Trade, it is essential to set a realistic take profit target for it. Being overambitious can lead to unnecessary loss. 

Below is how you should think about setting the take profit targets for your trades when trading with the Pullback Trading Strategy – 

  • Bullish Trade: For a bullish trade, where the prediction is that the market will revert to an uptrend, take the distance between the previous low and the previous high, and add that distance to your current entry point.
  • Bearish Trade: For a bearish trade, where the prediction is that the market will revert to a downtrend, take the distance between the most recent high and the most recent low, and subtract it from your entry point to get your profit target for the trade.

Trading Strategy 2: Breakout Strategy

Irrespective of how strong a Support or a Resistance level is, at some point, the price will violate its integrity and breaks through it. This is the premise on which the Breakout Trading Strategy for Trading or Price Channels is based. 

Whether you are buying or selling, this strategy predicts that during an uptrend or a downtrend, price action will continue its trajectory and break beyond the limits that are set by the Trading Channel. 

Similar to the Pullback Trading Strategy described in the previous section, there are three stages to trade using the Breakout Trading Strategy as well. These three stages are as follows –

  • Determining Trade Entry
  • Determining Stop Loss Target
  • Determining Take Profit Target

Now, let us briefly discuss each of these three stages for the Breakout Trading Strategy.

Determining Trade Entry

As discussed earlier, for a true Trading or Price channel to occur, there are two conditions that must be met. These are –

  1. There must be at least two swing highs and two swing lows used in drawing the Support (Lower Band) and the Resistance (Upper Band) levels of the channel. 
  2. The Upper and the Lower Band of the channel must run near parallel to each other. 

Similar to the Pullback Trading Strategy discussed above, you must not even look for a trading opportunity using Price Channels unless these above-stated conditions are met.

If the above-listed conditions hold true, you have identified a true Trading or Price Channel structure. In such scenarios, you can look for a breakout trade entry as follows –

  • Bullish Breakout Trade: For entering a Bullish Breakout trade, wait for the price to close above the Upper Band (or the Resistance Level) of the channel. Once the price closes above the Upper Band, wait for a trend continuation signal using tools such as the Continuation Candlestick Patterns and enter a buy trade.
  • Bearish Breakout Trade: To enter a Bearish Breakout trade, wait for the price to close below the Lower Band (or the Support Level) of the channel. Once the price closes below the Support Level, wait for a trend continuation signal and enter a sell or a short sell trade.      

When entering breakout trades using Trading or Price Channel, it is also important to look at the trading volume as well. A real breakout will carry momentum in it. Therefore, a surge in the momentum of price change and an increase in the trading volume of the security can be treated as confirmation signals for breakout trades as well. 

This is where volume indicators such as OBV (On-Balance Volume) will come into play. Hence, for more accurate and reliable breakout trade entries, you should look for a considerable shift in the OBV alongside the breakout of the price from the channel. 

Determining Stop Loss Target

With Breakout Trading Strategy, you can determine your stop-loss using the following guidelines –

  • For Bullish Breakout Trades, set your stop-loss target just a few points under the Upper Band (or the Resistance Level) of the Trading Channel.
  • Similarly, in the case of Bearish Breakout Trades, you should set your stop loss just a few points above the Lower Band (or the Support Level) of the channel.  

This stop-loss determination criteria described above is a conservative one. If you are willing to trade aggressively, you can make several amends to these criteria. 

To make less conservative stop loss decisions, in situations where you have more confidence in the market to be on your side of the trade, stop-loss with the Breakout Trading Strategy can be moved to the middle of the channel, which should be the 50% Fibonacci retracement level within the channel. (This is where the Fibonacci retracement level can also be leveraged) 

Determining Take Profit Targets

To determine the take profit targets for existing breakout trades entered using a Trading or Price Channel, you will need to rely on various complementary concepts in Technical Analysis. 

Personally, I rely heavily on Fibonacci Extension Levels to determine my trade exit levels with this strategy. But, there are several additional reliable methods/tools that you can consider for this task as well. These complementary methods/tools include – Moving Average Crossovers, Divergence, Candlesticks, and Chart Patterns.   

Advantages and Limitations of Trading with Trading or Price Channel

Just as with any other trading tool, there are several advantages and limitations associated with trading Price Channels. In order to make informed trading decisions, it is important to be aware of these advantages and shortcomings. 

Therefore, in this section, let us briefly discuss some of the important advantages and limitations of trading channels. 

Advantages of Trading with Trading or Price Channels

Listed below are several key advantages of Trading or Price Channels –

  1. Trading with channels is relatively simple and straightforward. Hence, Trading or Price Channels are very beginner-friendly.
  2. Channels are characterized by well-defined Support and Resistance levels. Hence, devising trade entry and exit strategies around them is easy.
  3. When combined with other complementary methods in technical analysis, Channels are known to provide very reliable trading signals.

Limitations of Trading or Price Channels

Listed below are several key limitations of Trading or Price Channels –

  1. Signals from Trading or Price Channels are not as reliable if price frequently violates the integrity of its Support and Resistance levels.
  2. Channels are based on historical price data. Hence, the predicted future price moves via Channels are not guaranteed. 
  3. Trading or Price Channels can only be confirmed after two swing highs and two swing lows are produced on the price chart of a security. It can be challenging to trade using them, during their early structure development stages. 

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Conclusion 

To conclude, Trading or Price Channels are a form of analysis tool in technical analysis. At its core, Trading Channels provide traders with an easy method to identify the Support and Resistance levels on the price chart of the security that they are trading. Based on these levels that Channels indicate, various trading strategies can be formulated. 

From the construction standpoint, a Trading or Price Channel comprises two horizontal or trend lines (the Upper Band and the Lower Band) that run near parallel to each other. Within these two horizontal or trend lines, the price oscillates between peaks and troughs. 

Finally, when trading using the insights from Trading or Price Channels, you must remember that while Channels form a reliable and beginner-friendly analysis tool in trading, they do come with their own set of limitations. However, this should not deter you from incorporating Channels into your overall trading strategy, as these limitations can be easily tackled by combining trading signals from channels with signals from other complementary trading methods. 

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    Navdeep Singh

    Navdeep has been an avid trader/investor for the last 10 years and loves to share what he has learned about trading and investments here on TradeVeda. When not managing his personal portfolio or writing for TradeVeda, Navdeep loves to go outdoors on long hikes.

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