Price spends most of his time within trading ranges. On the chart, this results in the formation of a horizontal, ascending or descending trading channel.
Trading channels are one of the most common and important chart patterns. Indeed, for the most of the time, price tends to consolidate within a limited range of excursion, as manifestation of the buying and selling activities of market participants.
What is a trading channel?
A trading channel, whether horizontal, ascending or descending, is simply a range inside which price moves.
It spots areas of resistance and support in the market, where buying and selling orders produce a bounce-back toward the centre of the range itself.
The construction of a trading channel is easy. Simply draw a trend line, then project a parallel one:
In TradingView, you can use the “parallel channel” tool on the left bar of the instruments. If you don’t already use TradingView for your chart’s analysis I think you should reconsider your choice: it’s amazing and it’s completely free (if you stay basic).
How to use trading channels to spot the best entry points in the market
In the following paragraphs you will learn how to find the best entries in the market using trading channels. For first we will see how to trade inside ranges, then we will discuss about channel’s breakouts and how to exploit them.
1. Trade within a price range: two examples with an ascending and descending trading channel
After the formation of a trading channel, you can enter in the market every time price test one of the channel’s boundaries, if you wish.
This approach however, works best inside horizontal trading channels. Rather, if you are in an ascending or descending trading channel, I suggest you to trade only in the direction of the main trend.
Look at the picture below:
We are in an ascending channel, so in an uptrend phase. We don’t like to put ourselves against the market, so we decide to look for a long entry.
Where should we enter in this market?
Point 5 seems to be a good opportunity, since it is the first tradable one after the creation of the trading channel.
Now, you probably want to know why this should be a good point to enter in the market.
Think about what happen in this particular zone, and about what traders will do nearby this specific point.
They will insert sell or buy orders in the market? We are in an upward trendline, a zone of buying pressure, then we expect that price will likely to continue in the main direction of the market. We cannot be sure 100%, but it’s more plausible than not.
The result in this case was the following:
We can notice how, after a bit of consolidation, price start to grow following the direction of the previous trend. We can say that point 5 was a reliable entry point for a profitable trade.
In an opposite way, in a descending channel we simply “switch” the considerations. We search for a short point of entry when price test the upper band of the channel (point 6). In the following example you can see another profitable trade:
2. Channel’s Breakout: how to enter in the market when price moves outside trading ranges
A breakout occurs whenever price exit from the trading channel. It could happen both in the direction of the main trend, with price moving at a faster rate, or in an opposite direction when price action produce a reversal in the market.
Remember this basic concept: the longer it takes to have a breakout, the more powerful this last should be.
A. Continuation Breakout
Look at the ascending channel identified in the picture below. After some months of low volatility, price breaks the upper band of the channel and starts to move at a higher rate of growth (we talk about “acceleration” in price action).
In this case, where we should enter in the market?
The answer is not unique and depends on the entry filter you have set for your trading plan, like a closing price violation or a re-test of the broken level.
In this particular case concerning Microsoft we can notice that after a strong breakout (big market gap), price retrace and test the broken trend line of resistance (now a support). This represents a perfect entry point for a new trade in the direction of the market.
B. Reverse breakout
In the picture below, we can see the breakout of a descending channel in GBP/USD market.
In this case, the breakout occurred in a direction opposite to the overall market trend, with price action who broke above the upper band of the trading channel.
Even in this case, a re-test of the broken level represented a good entry point for a new profitable trade. In addition, waiting for a price confirmation, gave us the possibility to obtain a better risk-to-reward ratio.
Good, but now? Targets
Ok, now we know everything about how to enter a trade in trading channels. But what about targets? There’s a way to find a minimum possible reward for our trades?
Fortunately the answer is yes.
Once a breakout occurs, we can expect a minimum 1.1 target from the breakout point. Target is fixed considering the width of the broken channel, as shown below:
You can notice that I’ve inserted also the 2:1 and 3:1 price projections after the breakouts. This why in some cases, when the breakout is particularly strong, price might reach even these levels of extensions, providing a great opportunity to increase our risk-to-reward ratio.
Nested Trading Channels: Additional Targets
Price tends to moves between market structures. That’s why is quite common to find nested patterns like trading channels. Look at the picture below:
We can see a smaller ascending channels inside a greater one. When we have a breakout, before to reach the 1:1 price projection (target 2 in the chart), we need to be aware about the existence of a hidden target level (number 1 in the chart), formed by the upper band of the greater channel.
Since this latter is a major structure in the market, we should be aware about a possible price reaction nearby this zone. In this particular case price passed it without problems, but in other cases we might experience a re-bounce toward the inside.
Is it possible to anticipate a price breakout?
Well, we can only make guesses about future price behaviour, nevertheless looking at price action inside trading ranges we can spot possible early sign of strength or weakness.
Look at the picture below: price fail to retest the lower band of the ascending channel two times before the breakout. This identify a condition in which sellers gradually lose control, until buyers are able to acquire full dominance of the situation pushing price higher.
The importance of Volume in channel trading
Volume is the second most important indicator after price. It represents the amount of contracts or shares exchanged during a trading day.
Considering its entity, we can notice that before a breakout, volume should gradually subside to lower levels, touching in some cases its historical low level.
When volume is particularly contained, we should expect a breakout: look at the picture below to see a practical example.
What we have learned today
You should now have a complete understanding about horizontal, ascending or descending trading channel. You should also understand how to fix price target and how to spot early sign of a potential breakout.
I hope you enjoyed these contents. See you next time!