A trading channel is created by charting the price of an asset, such as stock or commodity futures. Two parallel trend lines are drawn on the chart between the asset’s support and resistance. The upper trend line links price highs or closes. The lower trend line links the price lows or closes. The area located within the two lines is known as the trading channel. The price remains within this defined space until a channel breakout, or price breakout, occurs in either direction. The trading channel gives traders a visual look at the trading range of an asset for a certain time period.
Typically, traders will sell an asset when the price approaches the top, which is the resistance level. Conversely, traders will buy an asset when the value gets close to the bottom. This is the support line. Many traders consider the trading channel to be a very reliable technical analysis tool for defining trend behavior. The trend lines are actually an aggregate of traders’ belief about the value of the asset. Trading channels illustrate the boundaries of this changing sentiment as values back away from resistance and springs off of support.
There are a variety of trading channels, such as horizontal or sideways channels, which can be found in markets that are trending up or down. This type of channel is not necessarily an indication that the prevailing trend is changing, but is indicative of a market that is in a resting or consolidation phase. This often occurs before the market makes its next move. Usually, the price breakout happens in the direction of the prior trend. To create a horizontal channel, draw a straight trend line that touches the most recent price high and a straight line that touches the asset’s price valley during the same time period.
Bullish or ascending channels are formed by constructing a conventional trend line along the bottom of support. A parallel line is constructed that meets the highest price point. Bearish or descending channels are created by drawing a trend line that follows along the top of resistance or price peak. Next, draw a parallel line at an angle similar to the downtrend line. This line should meet with the most recent price low.
There is not an existing rule or predetermined number of times that a price must meet the channel lines before traders should make buy or sell decisions. However, most traders look for at least two high point and two low points to validate a particular formation. Regardless of the trend, it is essential that both the trend and channel lines are drawn parallel to each other. Drawing the lines at the wrong angle will yield false conclusions. Traders typically anticipate where prices will go by computing the distance between the lines.
