The Channel chart pattern is one of the most common and easily-identifiable chart patterns. It also has a relatively high win rate (over 77%). These characteristics make it a very useful pattern for novice traders and professionals as well. In this article, you will learn how to trade stocks with the Channel chart pattern.
The channel pattern consists of two parallel trend lines which serve as boundaries for price action. The lower trend line serves as support and the upper trend line serves as resistance.
Fig. 1: Descending Channel pattern at the Dow Jones Industrial Average
Fig. 2: Ascending Channel pattern at Amazon stock
Channels can be either ascending – thus, both trend lines are pointing upwards – or descending – when both trend lines are pointing downwards.
Important note about channels: the more times the channel’s trend lines are validated (price touches them and retraces to the opposite direction), the stronger the pattern is. For example: the channel at figure 1 is strong and reliable pattern, as its support trend line was validated 5 times, and resistance trend line was validated 4 times.
Volume should confirm the pattern in the following way:
When price is advancing in the direction of the channel (upwards for ascending channels or downwards for descending channels), volume should increase as well. When price is advancing in the opposite direction volume should decrease. Volume is an indicator for the strength of trend. By confirming that volume supports the trend of the channel, we confirm that the pattern is validated and more reliable.
How To Trade?
Channels are traded in two main methods. The first one is to trade with the direction of the channel. That is, when price is touching the support trend line of ascending channel it is a signal to enter a long trade. When price is touching the resistance trend line of a descending channel, a short trade is signaled.
At the example above, price has touched the support trend line and began to reverse. The entry points are marked on chart. These trades usually have a tight stop loss just below the entry candle – a very low risk. Note that we trade only in the direction of the channel – we will not take short trades in ascending channels or long trades in descending channels.
The second trading method is at the breakout. Traders who trade breakouts enter when a trend line of the channel is broken, and a trade is issued to the direction of the breakout. Traders usually declare a breakout when price closes above or below the boundaries of the pattern. This is a more risky trading method, as breakouts are not objective and price sometimes retraces back to the channel, a phenomenon known as a ‘fakeout’.
In order to enter trades with higher win rate, traders may wait for a pullback to confirm the breakout. A pullback ocurs when price retraces to test the trend line it has broken. If the trend line is tested successfully, the breakout is validated and the trade is more likely to be successful.
Target is calculated using the measure rule, which is a standard method of calculating targets in chart patterns. First of all, calculate the size of the pattern – the distance between upper and lower trend line. Deduct this size from the breakout or pullback price – this is the projected target of the pattern.