What it means
When a price rises or falls in a fairly steady way, its highs and lows often line up along two roughly parallel lines. The upper line connects the highs and the lower line connects the lows.
The space between them is the channel, and the price tends to bounce around inside it. There are three basic kinds.
An ascending channel slopes upward and shows an uptrend, a descending channel slopes downward and shows a downtrend, and a horizontal channel shows a sideways market. Traders see a move to the lower line in an uptrend as a possible buying opportunity, and a move to the upper line as a possible time to take profits.
A popular version is the Donchian channel, which is built mechanically instead of by drawing lines by hand. The upper band is the highest price over the last chosen number of days, and the lower band is the lowest price over the same period.
A close above the upper band suggests the price is breaking out upward, while a close below the lower band suggests a breakdown. Channels also give a feel for volatility.
A wide channel means prices swing a lot, while a narrow one means they are calm. A narrowing channel often comes before a large move, though it does not show which direction.
The main caution is that channels are drawn with judgement, and two analysts may draw them differently. A price can break through a line without continuing, which is called a false breakout.
Most traders therefore wait for confirmation, such as a close beyond the line or an increase in volume, before acting. For non-specialists, the useful idea is that a channel gives a visual range for what is normal.
When the price moves outside it, something has changed and the reason deserves attention.
In practice
Real-world examples.
Example
A trader sees a share rising in an ascending channel, with the lower line at $30 and the upper line at $36. When the price dips to $30.50, she buys and sets a target near $35. She places a stop loss at $29 in case the channel fails. The trade risks about $1.50 to gain about $4.50, a ratio of three to one.
Example
A commodity buyer plots a horizontal channel for a metal that has traded between $8,000 and $8,800 a tonne for three months. He agrees purchases when the price is near the lower line. He holds off when it climbs to the top. This simple discipline reduces his average purchase cost over the year.
Example
A fund uses a 55-day Donchian channel as a rule for entering trends. When a currency pair closes above the 55-day high, the fund buys. The rule is applied the same way every time, which removes guesswork. The fund accepts that some signals will fail and relies on the larger winners to pay for the losers.
Formula
Calculation
Donchian channel: upper band = highest high over n periods; lower band = lowest low over n periods; midline = (upper + lower) / 2; width = upper - lower.
Over the last 20 trading days a share has a highest price of $52 and a lowest price of $44. The upper band is $52 and the lower band is $44. Midline = ($52 + $44) / 2 = $48. Width = $52 - $44 = $8, which is $8 / $48 = 16.7% of the midline. If the share closes at $53 tomorrow, it has broken above the upper band. A wider channel suggests higher volatility, so a trader would set a larger stop loss than in a narrow channel. For example, with an $8 width, a stop of $1 below the lower band leaves room for normal swings, while the same stop would be hit too easily in a $2 channel.Case study
Seen in the real world.
Stonebridge Materials is a fictional listed company used for illustration. Its share price had risen in a clear ascending channel for eight months, with a gap of about $6 between the upper and lower lines.
An analyst noticed that the price fell below the lower line on heavy volume after a profit warning. Instead of treating it as a dip to buy, she reasoned that the pattern of the trend had changed.
The illustrative analyst advised clients to reduce the holding. The shares fell a further 12% over the next two months before settling in a new, lower channel.
Watch out
Common mistakes.
- Assuming a channel will hold forever. Prices can and do break out, especially after news.
- Treating every touch of the line as a trade signal. Wait for confirmation before acting.
- Drawing lines to fit a story. Use consistent rules, such as the same number of touches, so the analysis is not biased.
Questions
People also ask.
How many touches make a valid channel?
Analysts usually look for at least two touches on each line, and more touches give more confidence.
What does a breakout mean?
It means the price has moved outside the channel, which may signal a new trend or a short-lived spike.
Is a price channel the same as a trading range?
A horizontal channel is a trading range, while channels can also slope up or down. The slope tells you the direction of the underlying trend.
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