What are trading channels?

What are trading channels?

Trading channels
Image by @FotoArtist

Trading channels are mainly drawn as parallel support and resistance trend lines. You’d find them on price charts for any financial market rather than below as an oscillator. They’re basically indicators that help you to identify strong support and resistance levels and to define the market’s trend. 

They’re also a form of technical analysis that can be used to signal a change in trend. You’re more than likely to hear a trading channel referred to as a ‘price channel’. 

What is channel trading?

Channel trading is the use and overlay of channels on a price chart, which you can use to make trading decisions.

But what do you need to consider when using price channels in this way? 

Trading channels help you define important support and resistance levels, which can help you to decide whether to buy or sell a particular market. They also determine levels for you to enter and exit a trade.

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How to use trading channels

What do we need to consider when using trading channels? The most important factor to consider is whether they’re indicating an uptrend, a downtrend or a sideways trend. 

It’s these characteristics that give you the different types of channels.

First, identify support and resistance levels from the channels. Next, define the trend direction. And then finally, look to buy at or near to channel support and sell towards channel resistance. 

If there’s a breakout from the channel, this can often be a sign of a more impulsive, significant move in the direction of the channel breakout. In this case the support would turn into resistance or vice versa and the resistance would turn into the support.

What are the different channel types?

The different trading channel types can be broadly split into two categories.

The first of which is ‘trend channels’, which can be further subdivided into three parts: 

  • Ascending Channels
  • Descending Channels
  • Horizontal Channels

The second type is ‘Envelope Channels’.

Ascending channels

Ascending Channels are drawn by firstly identifying an uptrend line. You can do this by connecting important support lows. 

Then, draw a line parallel above, connecting significant resistance highs. You can see this in action in the image below.

Ascending channel
Screenshot from TradingView

Descending channels

In contrast, a Descending Channel pattern is drawn by connecting important resistance highs — this is what creates your downtrend line. 

Similar to what you’ll have read above, a line parallel to this downtrend line can be formed by connecting significant support lows, as in the image below.

Descending channel
Screenshot from TradingView

Horizontal channels

A Horizontal Channel happens when there’s no definable trend in the market — neither up or down. The parallel lines that emerge define the sideways, range environment, which you’ll see in the image here.

Sideways channel
Screenshot from TradingView

Envelope channels

Rather than being straight, parallel lines, Envelope Channels are drawn based on data calculations. Unlike Ascending, Descending and Horizontal Channels, you’ll see that Envelope Channels can follow a more erratic path.

We’ll look further into Envelope Channels in the next lesson, but first, it’s worth seeing the example in action on this chart.

Bollinger bands
Screenshot from TradingView

What are the most popular trading channel indicators?

The most popular channel indicators, which you’re most likely to encounter when trading, are categorised as:

  • Donchian Channels
  • Bollinger Bands
  • Keltner Channels
  • Fibonacci Channels
  • Stoller Average Range Channels (STARC)
  • Linear Regression Channels

Let’s take a look at each of these in turn.

Donchian channels

Going back to its origins, the Donchian Channel was created by successful futures trader, Richard Donchian, in the middle of the 20th century.

The calculations for Donchian Channels (that you’ll see below) produce three lines on the price chart based on calculations of Moving Averages. 

The three lines produced are: 

  • A mid-range line 
  • An upper band (or channel) 
  • A lower band (or channel)

The primary use of Donchian Channels is to provide you with buy and sell signals. The indicator identifies extremes of bullishness and bearishness, which can highlight reversals alongside breakouts.

When it comes to these channels, here’s the calculations you’ll need to bear in mind:

Upper channel = Highest High in past N periods

Lower channel = Lowest Low in past N periods

Mid-Range line = (Upper channel – Lower channel)/2

Screenshot from TradingView

Bollinger bands

Bollinger Bands were developed by John Bollinger in the 1980s. He developed these as a way of indicating when the market price of an asset was overstretched in one direction — either overbought, or oversold.

Bollinger Bands are a set of price channels or envelopes around a simple moving average. They’re plotted two standard deviations above and below the simple moving average.

Essentially, with a Bollinger Band, you’ll notice three lines: 

  • The simple moving average (usually a 20-period simple moving average) 
  • The middle line (or band)
  • The upper and lower band

Bollinger Bands were designed to show when a market’s become stretched too far in either direction. This can help you with decisions on both market direction and buying or selling levels.

It’s also worth for you to note the concept of the Bollinger Band ‘squeeze’. 

This ‘squeeze’ is when the bands narrow inwards, towards each other. When this happens, it highlights a phase of low volatility. Usually, this indicates a likelihood of a breakout in the short-term — in either direction.

Bollinger bands
Screenshot from TradingView

Keltner channels

The Keltner Channel was devised by Chester Keltner in the 1960s. 

Again, these are a set of three lines — a mid-line and two envelopes or bands above and below the mid-line.

  • The middle line is known as an exponential moving average (EMA) — usually a 20 period EMA
  • The upper band is two times the Average True Range (ATR) above the EMA
  • The lower band is two times the Average True Range (ATR) below the EMA. The ATR is usually set at 10 periods

It’s important for you to recognise that the upper and lower bands of Keltner Channels will widen and narrow with volatility, which is measured by the ATR.

So, when price fluctuates between the bands, you can use the bands as support and resistance. 

But, be careful, as a forceful, impulsive breakout from the bands would signal a more bullish or bearish tone. This could mean a trend continuation and an extension in the direction of the breakout.

Screenshot from TradingView

Fibonacci channels

You’ll find that Fibonacci Channels are similar to Ascending and Descending Channels. This is due to their trend line. Once you’ve identified the trend line, a parallel line is drawn to create the channel. 

The next step is to apply Fibonacci levels and percentages, such as 23.6, 38.2, 50, 61.8, 78.6, 100, 138.2, 161.8, 200, 238.2 to the channel to create Fibonacci Channels

But why would you apply these levels and percentages? These Fibonacci Channel lines are effectively potential extension levels. You’ll find these useful if the price breaks out from the initial Ascending and Descending channels. 

Basically, Fibonacci Channels are support and resistance target levels above and below the channel. You can see this in action on the chart here.

Screenshot from TradingView

Stoller average range channels (STARC)

Developed by Manning Stoller in the early 1980s, Stoller Average Range Channels are better known by their acronym, STARC bands. 

They’re similar to the Keltner Channels, in that there are a set of three lines — a middle line and two bands above and below this line.

  • The middle line is a simple moving average (SMA), different to the EMA seen with Keltner Channels
  • The upper band is then a percentage/multiplier of the Average True Range (ATR) above the SMA
  • The lower band is a percentage/multiplier of the ATR below the SMA

As with the Keltner Channels, the upper and lower bands will widen and narrow with volatility, which is measured by the ATR. The percentage/multiplier of the ATR is for you to decide upon, although 200%, or two times is commonly used. 

The SMA is usually set between 5- and 10-periods.

Stoller channels
Screenshot from TradingView

Linear regression channels

Linear Regression Channels are also made up of three lines — the Linear Regression line and upper and lower channel lines. 

The Linear Regression line is a straight line that ‘best fits’ the prices between a start price and an end price. This line is called a ‘best fit’ because it’s positioned where there’s the least amount of space between the price points and the Linear Regression Line.

The upper and lower channel lines are then drawn parallel to the Linear Regression line — usually one or two standard deviations above or below the Linear Regression line. 

In the example for you below, you’ll notice that the Linear Regression line is similar to a moving average. It’s viewed as the mid-point of the trend — the equilibrium price of the trend. 

When price moves away from the Linear Regression line, you’d anticipate price to move back towards this line. 

Let’s take the example of an uptrend. If price moves below the lower line and then moves back within the channel, this would be a possible buy signal, for a reversion back to the Linear Regression line.

In a downtrend, if price moves above the upper line and then moves back within the channel, this would be a possible sell signal, for a reversion back to the Linear Regression line.

Linear regression channel
Screenshot from TradingView

Trading channels summary

Traditional trading channels use a primary indicator, the trend line. This is drawn directly onto the price and can show exactly how the price is behaving. Experienced traders tend to use secondary indicators to confirm the primary indicators signal.

Channels continue to be a popular choice for technical analysts due to this reason and is why it’s worth testing out if you’re still looking for a strategy to suit you.

In this lesson we’ve looked at what trading channels are and their unique characteristics. We’ve explored how to use these channels in your trading and the most popular trading channel indicators. 

This should now give you a platform to go ahead use channels as a routine part of your own financial market trading

In our next lesson, we’ll explore the second part of our guide to ‘What Are Trading Indicators?’.

Transcript

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