Trend Channels

How to trade using channels Trend channels overcome a glaring flaw of trendlines by giving a clear signal on when to exit and book profits. NARENDRA NATHAN      In the previous part of the technical analysis series, we explained trend lines. These help in trading, indicating a buy when the trend is up and a sell when it’s down. However, one shortcoming of this method is that it doesn’t provide a clear signal on when to exit a trade by booking profit. This can be overcome by using trend channels.      If you look at several trend lines closely, you will observe that in some cases the price that is being bounced from a trend line returns to the line after oscillating the same distance either way (up or down). If you connect these points, that is, the points from where the price starts reverting, you will get another line, popularly known as ‘return line’. Trend channels are formed when the original trend line and return line are almost parallel to each other.      Types of channels: Much like trend lines, trend channels can also be classified as uptrend and downtrend. An uptrend channel will climb up (see Uptrend channel), and is, therefore, considered bullish. The trading rule here is simple—buy when the price comes close to the rising main trend line (with a stop loss arrangement at the trend line value) and book profit when the price comes close to the return line. The active traders who want to make money by participating in the counter trend (one against the main trend) can also consider selling short close to the return lines, with a stop loss in place at the return line value.      A downtrend channel, on the other hand, is bearish and is a falling pattern (see Downtrend channel). The trading rule here is in contrast to that of the uptrend channel, that is, sell short when the price comes close to the falling main trend line (with a stop loss arrangement at the trend line value) and book profit when the price comes close to the return lines. Here again, the active traders who want to make money by participating in the counter trend can consider going long close to the return lines, with a stop loss in place at the return line value.  Trading rules       • While channel analysis helps investors take advantage of price oscillations, they need to be careful about any break in channels. This is because unlike the trend line analysis, a break in a trend channel is more complicated.       • A break (up or down) in the main trend line signifies that the investors’ expectation about the stock has changed and, therefore, it can be used to generate new buy or sell signals. Any decisive break in the downtrend line (see Downtrend channel) is a clear buy signal. Similarly, any decisive break in the uptrend line (see Uptrend channel) is a clear sell signal. In both the cases, the main trend line value should be used as the stop loss.       • A break in the return line, on the other hand, indicates that the trend is becoming stronger. So traders can consider taking a fresh long position if the price goes decisively above the return line of an uptrend channel. Similarly, traders can considertaking a fresh short position if the price goes decisively below the return line of a downtrend channel. However, only seasoned traders should try this because the break may be temporary and the price may get back to the trend channel in a short period.       • The prices that are unable to reach the return line (known as return line failure) also give a hint about a possible trend reversal. In the Coal India chart, the prices failed to reach the return line just before the break in its uptrend channel. Since the return line failure indicates that the channel is weakening, investors need to be cautious with their trades when prices come back to the original trend line.