Trading price channels can be one of the simplest, most profitable trading strategies in the market. Finding a longer term channel is like finding a nice gold nugget. We’ll be discussing where to look for price channels, what types of channel line drawing tools are available, how to draw price channels and how to trade them for profit.
Where Should I Look For Price Channels?
Price channels can be found on any trading instrument on any time frame. Our focus will be on Forex currency pairs, but price channels can be also found on Equities, Futures, Commodities and other trading instruments. Having said that, there are some caveats to consider.
The longer the time frame on which you find the price channel, the larger your targets should be – but also the larger your stop loss levels should be. By the same token, if you find the price channel on a short term time frame, say less than 15 minutes, you must be sure you can make enough profit on the trade to cover the spread and commissions.
Obviously, with the longer time frames, you will have to wait much longer for the trade to work out. You can potentially make a 1000 pip trade (you can see one of those on the USD/JPY daily down trend channel that’s currently in place), but it will take some time for that to happen. And since you must use a larger stop loss, you will be using a smaller trade size to control your risk, so the trade won’t be as profitable as it could be on a smaller time frame with a smaller target. On the other hand, this 1000 pip trade progressed for 19 trading days without intervention, so the longer time frames are definitely more “hands off”.
Which Channel Tool Should I Use?
Metatrader 4 has several channel tools available. They can be found under the Insert/Channels menu item. Many traders will use the Linear Regression or the Standard Deviation tool, but I prefer the Equidistant Channel tool. The Linear Regression and Standard Deviation tools use those mathematical techniques to determine the location of the trend channel lines, but I find the resulting lines don’t touch as many points (price candle wicks and bodies) on the channel when the channel is not regular (which is most of the time, in my experience.)
How Do I Draw Price Channels?
The simplest way to draw a price channel is to use the Equidistant Channel tool and place the main channel line above a downtrend and below an uptrend. Find the location and angle of the line that will fit the largest number of the candles in the trend. Remember that a line is never just a line, it’s always a zone. So your trend line should touch as many wicks as possible. The end of candle bodies is also an appropriate place to consider placing your line. Sometimes, wicks will push through lines for a few pips (the number of pips depends on the time frame upon which you’re placing your line) or not quite reach the line. Occasionally, you’ll see a wick push through the line, but the candle will close on the near side of the line. The idea is to place the line where the most traders will think “this is where the line is, I’m going to put a reversal order right here”.
After you place the main line, look for the best fit for the secondary line. Again, the point at which it touches the most wicks. You may need to readjust the main line to get a better angular fit for the secondary line. Use both lines to determine the best channel location.
How Do I Trade Price Channels?
Once you’ve determined the best location for the channel, the rest is fairly simple. Notice I said “simple” but not “easy”. At this point, just enter an order when the price action touches your trend channel line. If the channel is wide enough, you can trade it in both directions, but ideally you will want to trade primarily in the direction of the price channel. In other words, you will want to sell a downtrend channel and buy an uptrend channel. The probability of success will be higher. The reason is that, for example, if you buy at the bottom of a downtrend channel, the price action could just go sideways in the channel until it touches the top channel line and then drop.
One other reason why trading in the direction of the trend channel would be beneficial is when the price action breaks out of the channel. After breaking the trend channel and moving away (against the direction of your trade), price action will often pull back and retest the prior broken line before it proceeds in the direction of the break. That will be your opportunity to close your trade in small profit or small loss, reducing the risk of channel trading quite a bit. In the chart you can see a channel on the EUR/CHF 4 Hour chart from August 2016. You could have entered a long trade for a bounce off the bottom of the channel in any of several places. Price moved up the channel nicely and even pushed past the center of the channel. In this example, I’m suggesting perhaps you didn’t close the trade on the pop up because you were holding for it to hit the top of the channel. Instead, price turned and broke the bottom of the channel. It then moved away from the channel and made a candle that didn’t touch the channel at all. But before it dropped hard, it retested the bottom of the channel. This is your opportunity to get out of the trade with profit. As you can see, right after retesting the channel, it dropped like a rock.
Determine your stop loss by going back to each prior touch of either trend channel line and measure the number of pips the price pushed through each time and determine the farthest pushed through. Then place your stop a few pips past that.
As for a target, you can hold for the opposite line if you like, or you can target anywhere in the middle. You can set your original position to break even when price hits the center of the channel and add to your position if price pulls back to the same line from which you entered.
Be sure to size your trade so you are not exceeding your risk parameters if the trade hits the stop loss. Always follow your trading rules. Practice this strategy on a demo account for a while until you are comfortable with it.
As always, be safe. Don’t trade too much size. Never bet the farm. Have fun!