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CHANNEL TRADING SYSTEMS
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Prices often flow in channels, the way rivers flow in valleys. When a river touches the right edge of its valley, it turns left. When a river touches the left rim of its valley, it turns right. When prices rally, they often seem to stop at an invisible ceiling. When they fall, they often seem to hit an invisible floor.

Channels help traders identify buying and selling opportunities and avoid bad trades. The original research into trading channels was conducted by J. M. Hurst and described in his 1970 book, The Profit Magic of Stock Transaction Timing.

Four Ways to Construct a Channel

Channels help traders because their boundaries show where to expect support or resistance to come into the market. There are four main ways to con­struct a channel:

•  By drawing a channel line parallel to a trendline

•  By plotting two lines parallel to a moving average: one above it and
another below.

•  Same as above, only the distance between each line and the moving
average changes depending on the market's volatility (Bollinger
bands).

•  By drawing a moving average of the highs and another of the lows.

Channels parallel to trendlines are useful for long-term analysis, especially on the weekly charts. Channels around moving averages are useful for short-term analysis, especially on daily and intraday charts. Channels whose width depends on volatility are good for catching early stages of major new trends.

Support is where buyers buy with greater intensity than sellers sell. Resistance is where sellers sell with greater intensity than buyers buy (see Section 19). Channels show where to expect support and resistance in the future.

A channel's slope identifies a market's trend. When a channel lies flat, you may trade all swings within its walls. When a channel rises, it pays to trade only from the long side, buying at the lower wall and selling at the upper wall. When a channel declines, it pays to trade only from the short side, shorting at the upper channel wall and covering at the lower wall.

Moving Average Channels

A 13-day exponential moving average can serve as the backbone of a channel (see Section 25). Draw upper and lower channel lines parallel to it. The width of a channel depends on the coefficient selected by the trader.

Upper Channel Line = EMA + Channel Coefficient • EMA Lower Channel Line = EMA - Channel Coefficient • EMA

You need to adjust channel coefficients until a channel contains 90 percent to 95 percent of the price action. A channel shows the boundaries between normal and abnormal price action. It is normal for prices to be inside a channel, and only unusual events push them outside. The market is undervalued below its lower channel line and overvalued above its upper channel line.

For example, in 1992, the channel coefficient on the daily chart of the S&P 500 futures was 1.5 percent. If the 13-day EMA stood at 400, then the upper channel line was 406 [400 + (400 • 1.5/100)] and the lower channel line was 394 [400 - (400 • 1.5/100)].

•  Same as above, only the distance between each line and the moving
average changes depending on the market's volatility (Bollinger
bands).

•  By drawing a moving average of the highs and another of the lows.

Channels parallel to trendlines are useful for long-term analysis, especially on the weekly charts. Channels around moving averages are useful for short-term analysis, especially on daily and intraday charts. Channels whose width depends on volatility are good for catching early stages of major new trends.

Support is where buyers buy with greater intensity than sellers sell. Resistance is where sellers sell with greater intensity than buyers buy (see Section 19). Channels show where to expect support and resistance in the future.

A channel's slope identifies a market's trend. When a channel lies flat, you may trade all swings within its walls. When a channel rises, it pays to trade only from the long side, buying at the lower wall and selling at the upper wall. When a channel declines, it pays to trade only from the short side, shorting at the upper channel wall and covering at the lower wall.

Moving Average Channels

A 13-day exponential moving average can serve as the backbone of a chan­nel (see Section 25). Draw upper and lower channel lines parallel to it. The width of a channel depends on the coefficient selected by the trader.

Upper Channel Line = EMA + Channel Coefficient • EMA Lower Channel Line = EMA - Channel Coefficient • EMA

You need to adjust channel coefficients until a channel contains 90 percent to 95 percent of the price action. A channel shows the boundaries between normal and abnormal price action. It is normal for prices to be inside a channel, and only unusual events push them outside. The market is undervalued below its lower channel line and overvalued above its upper channel line.

For example, in 1992, the channel coefficient on the daily chart of the S&P 500 futures was 1.5 percent. If the 13-day EMA stood at 400, then the upper channel line was 406 [400 + (400 • 1.5/100)] and the lower channel line was 394 [400 - (400 • 1.5/100)].

•  Same as above, only the distance between each line and the moving
average changes depending on the market's volatility (Bollinger
bands).

•  By drawing a moving average of the highs and another of the lows.

Channels parallel to trendlines are useful for long-term analysis, especially on the weekly charts. Channels around moving averages are useful for short-term analysis, especially on daily and intraday charts. Channels whose width depends on volatility are good for catching early stages of major new trends.

Support is where buyers buy with greater intensity than sellers sell. Resistance is where sellers sell with greater intensity than buyers buy (see Section 19). Channels show where to expect support and resistance in the future.

A channel's slope identifies a market's trend. When a channel lies flat, you may trade all swings within its walls. When a channel rises, it pays to trade only from the long side, buying at the lower wall and selling at the upper wall. When a channel declines, it pays to trade only from the short side, shorting at the upper channel wall and covering at the lower wall.

Moving Average Channels

A 13-day exponential moving average can serve as the backbone of a channel (see Section 25). Draw upper and lower channel lines parallel to it. The width of a channel depends on the coefficient selected by the trader.

Upper Channel Line = EMA + Channel Coefficient • EMA Lower Channel Line = EMA - Channel Coefficient • EMA

You need to adjust channel coefficients until a channel contains 90 percent to 95 percent of the price action. A channel shows the boundaries between normal and abnormal price action. It is normal for prices to be inside a channel, and only unusual events push them outside. The market is undervalued below its lower channel line and overvalued above its upper channel line.

For example, in 1992, the channel coefficient on the daily chart of the S&P 500 futures was 1.5 percent. If the 13-day EMA stood at 400, then the upper channel line was 406 [400 + (400 • 1.5/100)] and the lower channel line was 394 [400 - (400 • 1.5/100)].

Adjust channel coefficients at least once every three months to make a channel contain 90 percent to 95 percent of prices. If prices keep blowing out of a channel and staying outside for more than a few days, that channel should be widened. Too many reversals within the channel without reaching its walls indicate falling volatility, and that channel should be tightened.

Volatile markets require wider channels, and quieter markets require nar­row channels. Long-term charts require wider channels. As a rule of thumb, weekly channel coefficients are twice as wide as daily ones.

Mass Psychology

An exponential moving average reflects the average consensus of value during the time covered by that average (see Section 25). When prices rise above the average consensus of value, sellers see an opportunity to take profits on long positions or go short. When they overpower the bulls, prices decline. When prices fall below the moving average, bargain hunters step in. Their buying and short covering by bears lift prices, and the cycle repeats.

When prices are near their moving average, the market is fairly valued. When prices are at or below the lower channel line, the market is undervalued. When prices are at or above the upper channel line, the market is over­valued. Channels help traders find buying opportunities when the market is cheap and shorting opportunities when the market is dear.

The market is like a manic-depressive person. When he reaches the height of mania, he is ready to calm down, and when he reaches the bottom of his depression, his mood is ready to improve. A channel marks the limits of mass optimism and pessimism. Its upper line shows where bulls run out of steam, and its lower line shows where bears become exhausted.

Every animal fights harder closer to home. The upper channel line shows where bears have their backs against the wall and fight off the bulls. The lower channel line shows where bulls have their backs against the wall and fight off the bears.

When a rally fails to reach the upper channel line, it is a bearish sign. It shows that bulls are becoming weaker. If a rally shoots out of a channel and prices close above it, it shows that the uptrend is strong. The reverse rules apply in downtrends.

Channels help traders who use them remain objective when others get swept up in bullish or bearish hysteria. If prices touch the upper channel line,

you see that mass bullishness is being overdone and it is time to think about selling. When everyone turns bearish but prices touch the lower channel line, you know that it is time to think about buying instead of selling.

Trading Rules

Amateurs and market professionals handle channels differently. Amateurs bet on long shots —they tend to buy upside breakouts and sell short downside breakouts. When an amateur sees a breakout from a channel, he hopes that a major new trend is about to begin and make him rich quick.

Professionals trade against deviations and for a return to normalcy. It is normal for prices to remain within channels. Most breakouts are exhaustion moves that are quickly aborted. Professionals like to fade them —trade against them. They sell short as soon as an upside breakout stalls and buy when a downside breakout stops reaching new lows.

Breakouts can produce spectacular gains for amateurs when a major new trend blows out of a channel. Amateurs occasionally win, but it pays to trade with the professionals. Most breakouts are false and are followed by reversals.

Moving average channels can be used as a stand-alone trading method or combined with other techniques. Gerald Appel has recommended the following rules for trading with channels:

•  Draw a moving average and build a channel around it. When a chan­
nel is relatively flat, the market is almost always a good buy near the
bottom of its trading channel and a good sell near the top.

•  When the trend turns up and a channel rises sharply, an upside pene­
tration of the upper channel line shows very strong bullish momentum.
It indicates that you will probably have one more chance to sell in the
area of the highs that are being made. It is normal for the market to
return to its moving average after an upside penetration, offering an
excellent buying opportunity. Sell your long position when the market
returns to the top of the channel.

•  The above rule works in reverse during sharp downtrends. A breakout
below the lower channel boundary indicates that a pullback to the
moving average is likely to occur, offering another opportunity to sell
short. When prices return to the lower channel line, it is time to cover
shorts.

The best trading signals are given by a combination of channels and technical indicators. Indicators give their strongest signals when they diverge from prices (see Figure 45-1). A method for combining channels and divergences has been described by Manning Stoller in an interview with this author.

•  A sell signal is given when prices reach the upper channel line while
an indicator, such as Stochastic or MACD-Histogram, traces a lower
top and creates a bearish divergence. It shows that bulls are becoming
weak when prices are overextended.

•  A buy signal is given when prices reach the lower channel line while
an indicator traces a higher bottom and creates a bullish divergence. It
shows that bears are becoming weak when prices are already low.

We must analyze markets in more than one timeframe. Go long when prices are rising from the bottom to the top of the channel on both weekly and daily charts. Sell short when prices are sinking from the top to the bottom of the channel on both weekly and daily charts.

6. Go long below the moving average when the channel is rising, and
take profits at the upper channel line. Go short when the channel is
falling, and take profits at the lower channel line.

Standard Deviation Channels (Bollinger Bands)

Standard Deviation Channels have been proposed by Perry Kaufman in his book, The New Commodity Trading Systems and Methods, and popularized by analyst John Bollinger. The unique feature of Bollinger bands is that their width changes in response to market volatility. Trading rules for them differ from those for other channels.

•  Calculate a 21-day EMA.

•  Subtract the 21-day EMA from each closing price to obtain all the
deviations from the average.

•  Square each of the deviations and get their sum to obtain the total
squared deviation.

•  Divide the total squared deviation by the EMA length to obtain the
average squared deviation.

Trading with Channels and Indicators

A moving average reflects the average consensus of value. A channel or an envelope must be adjusted until it contains 90 percent-95 percent of all data. The upper channel line shows where the market is overvalued. The lower channel line shows where it is undervalued. It pays to buy in the lower half of a rising channel and to sell short in the upper half of a falling channel. Channels work best when their signals are combined with indicator divergences.

Bullish divergences in July and October occurred when the Swiss Franc was undervalued, near its lower channel line. These buy signals led to strong rallies. Bearish divergences occurred in August and November, when the Swiss Franc was overvalued, near its upper channel line. These sell signals were followed by sharp breaks. Combining channels with divergences allows you to trade against the market crowd at key turning points.

5. Take the square root of the average squared deviation to obtain the standard deviation.

These steps, outlined by John Bollinger, can be performed by many software packages for technical analysis. A Bollinger band becomes wider when volatility increases and narrows down when it decreases. A narrow Bollinger

band identifies a sleepy, quiet market. Major market moves ted to erupt from flat bases. Bollinger bands help find transitions from quiet to active markets.

When prices rally outside a very narrow Bollinger band, they give a buy signal. When they drop out of a very narrow Bollinger band, they give a sig­nal to go short. When prices pull back to their channel from the outside, it is time to close out positions.

Bollinger bands are especially useful for options traders. Options prices depend heavily on the swings in volatility. Bollinger bands help you buy when volatility is low and options are relatively cheap. They help you sell options when volatility is high and options are expensive.

More on Channels

Some traders use channels whose upper line is a moving average of the highs and whose lower line is a moving average of the lows. They appear more ragged than other channels. A trader has to choose a smoothing period for these channels. Here, as elsewhere, a 13-day EMA is a safe bet. A 13-day EMA of the highs creates the upper channel line, and a 13-day EMA of the lows creates the lower channel line.

One of the popular technical indicators is the Commodity Channel Index (CCI). It is based on the same principles as channels —it measures deviations from the moving average. If you use channels in trading, you may dispense with the CCI. Channels are better because they keep you visually closer to prices.

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