Today’s blog post focuses on how traders can use trend channels to their advantage when tackling trends, reversals and sideway price action. We will be discussing the best channel characteristics, channel expansions such as overthrow and under throw, and angles.
The best trend channels are characterized by a few important aspects:
- A good angle is visible which is not to steep nor too shallow;
- There are multiple price hits on the channel (minimum 4);
- Price respects the internal channel lines;
- Most price action is contained in the channel;
- Some of the price action can be outside of the channel.
Let us now review these points in more detail.
A trend channel is not supposed to be too steep or too shallow. A trend channel needs to have a balanced angle because then price is moving in a rhythm that is showing trend strength and sustainability.
Too steep channel:
This is not a trend but a momentum or impulse. Price can keep moving strongly within the momentum but eventually price will be lose its steam and need to make a bigger correction. The correction will break the channel because of its steep angle.
Too shallow channel:
In this case price is not showing sufficient momentum in the direction of the trend. A weak angle in fact shows a corrective pattern.
In this case price is not even able to build an angle, which means that price is building a range or sideways price action zone. Price cannot trend if it’s moving flat.
What is good, too shallow and too steep? These terms are very discretionary but we will try to quantify them, although they remain rough figures at best.
First of all, it’s best to use a chart setting where 150 to 200 candles are visible. This chart setting shows the best market memory.
Secondly, an angle of 30-45 degrees is considered to be an optimal angle for a trend channel. Anything below 30 degrees is shallow and above 45 degrees is steep. Steeper and shallower channels are still useful and good channels but are not considered trend channels.
Thirdly, a steep channel mostly has very impulsive price action. A trend channel will have both momentum and corrections which give it the medium angle. A sideways or shallow channel has only corrective price action but no momentum.
The minimum number of hits on the channel is 4. Anything lower than 4 is considered a potential channel. A channel becomes more established and valuable when more hits are visible.
In case of a downtrend channel we need to see 3 hits on the bottom. The 3rd hit on the bottom in fact changes the potential trend channel into a confirmed downtrend channel. The 4th touch is connected to a top.
In case of an uptrend channel we need to see 3 hits on the tops. The 3rd hit on the top changes the potential trend channel into a confirmed uptrend channel. The 4th touch is connected to a bottom.
There is nothing wrong with drawing multiple channels on the chart as long as it has relevance for your analysis. Often price is able to respect multiple trends lines and channels. Eventually of course one of the channels and trend lines will become obsolete and then a trader can remove the tool.
Price action needs to be within 30 pips from the top or bottom of the channel on a 4 hour or daily chart to be able to consinder it a full hit on the channel.
Internal channel lines
A good trend channel has internal lines which are respected by price action. There are 3 internal lines, which consist of a middle line and 2 quarter lines. Well formed trend channels will have price action which respects the middle line as it tends to act as support and resistance.
The quarter levels are important too:
- Selling in the top quarter or half of a downtrend channel is ideal because there is lots of space within the trend.
- Selling in the bottom quarter of a downtrend channel is dangerous because there is no space before price reaches the bottom of the channel.
- Buying in the bottom half or quarter of an uptrend channel is ideal because there is lots of space within the trend.
- Buying in the top quarter of a downtrend channel is dangerous because there is no space before price reaches the top of the channel.
Price action versus channel
The value of a trend channel diminishes if too much price action is hanging outside of it. But some price action is allowed to be below or above it. This is technically called an overthrow and under throw. Price has then overextended beyond the channel but eventually still reverts back into the channel. It’s OK to place a channel on the chart which cuts through parts of price action. Preferably the channel only has wicks outside of its boundaries but even entire candles are acceptable if this increases the number of channel hits or improves the channel angle.
Occasionally price will not be making an overthrow or under through but it will actually break the channel. It could break the channel in the opposite direction of the trend and indicate a potential reversal break. Or it could break the channel in the same direction and in fact accelerate the trend. Whether price manages to build a high or low outside of the channel OR whether price managest to post 1-3 full candles outside of the channel are important factors to analyze if price has overextended or has broken the channel.
Cheers and good trading,
Nenad and Chris
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