Breakouts from a channel
This lesson will cover the following
- Most breakouts to the upside from bull channels fail
- Channels act in a similar way to flags
- Signs of channel strength
As we already said, channels can be viewed as sloping trading ranges. As such, many of the attempts by prices to breakout either from the upper area or from the lower area of the channel usually fail.
In a bull channel, both buyers and sellers demonstrate activity, but buyers seem to be more tenacious, so this explains why the channel has a slope upwards. Both sides consider it appropriate to enter into trades in the middle of the channel, but as soon as prices approach the upper area of the channel, buyers grow more concerned that a breakout to the upside will likely not occur. Because of this, they will exit some of their long positions. Sellers, on the other hand, will go short even with greater impetus close to the upper area of the channel, as prices at which to short are better.
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As the price approaches the lower area of the channel, sellers will be less likely to go short at these levels, while buyers will go long impetuously. A bounce from the trend line will occur.
As the bull channel develops, the price will usually get below the channel a few times, so the trend line needs to be placed again. This way the channel will broaden.
The ultimate result usually is a breakout to the downside, sufficiently strong to be followed by a lower high and a lower low. As these two appear on the chart, some traders will begin to construct a bear channel.
Most breakouts to the upside from bull channels fail
If buyers manage to eventually overpower sellers in the market and produce a breakout to the upside, the latter may last for several bars. Buyers are likely to consider the market as overbought, so they may exit, recording gains. They will probably not look to go long again until the price retraces a bit.
The magnetic pull of the middle area of the channel, which we already mentioned, will usually drag prices back inside the channel, thus, this will not be an actual breakout, but a buy climax instead. This climax may trigger a two-legged retracement (lasting for about 10 bars), which will eventually breach below the channel. When the price breaks out to the downside and the selling is still present, the move downwards may be equal to about the height of the channel.
Sellers are probably aware that the buy climax may be followed by a retracement, so they will begin to short heavily. In addition to that, buyers will exit their long positions, thus, selling pressure is likely to be created. If the latter appears to be strong, the retracement down may even turn into a down trend.
Channels act in a similar way to flags
As every trend channel is a trading range with a slope, a bull channel, regardless of its steepness, will eventually produce a breakout to the downside. So, it can be viewed as a bear flag, even if no down trend was to be detected before it. Institutional bulls will probably take their profits and look to go long again only after a huge pullback has occurred. What is more, this pullback needs to extend to the beginning of the channel, where these bulls bought earlier. This, to some extent, explains why channels often cause a retracement, which touches the lower area of these channels.
Institutional bears, on the other hand, will begin to sell heavily just when institutional bulls quit their buying. These bears will probably take their profits in proximity to the very bottom of the channel, where institutional bulls will look to renew their buying.
As a bull channel acts as a bear flag, it is logical to be traded as such. Respectively, every bear channel can be considered as acting as a bull flag and traded as such. An uptrend may be or may not be present before it, but that is of little importance.
A breakout to the downside from a bear channel may be just a sell climax, which will lead to a two-legged retracement back inside the channel, that will eventually breach above the channel.
Signs of channel strength
A channel is usually stronger, if both lines are closer to one another and the slope is steeper (the so called tight channel). This implies greater momentum.
It is a risky move to trade the first breakout against the trend, if the channel appears to be strong. This whole channel may appear as a spike, when viewed on a higher time frame. In a steep bear channel, having pullbacks within it, consisting of only one bar, a trader would better not buy breakouts above the preceding bar. It is more appropriate to wait for a breakout pullback. If such occurs and the reversal up appears strong (2-3 large-sized bull trend bars within the past several bars), this pullback may be bought. If a rally occurs, the chance of even higher prices increases.
The chance of a long position to produce gains is higher, if the price rally goes above the Exponential Moving Average, while the first pullback remains above it. In case the pullback occurs below the EMA, this suggests that buyers are not that strong, while the odds of another leg up decrease.
If the price continues to fall after the breakout to the upside, then it obviously was a fakeout and the downtrend may be resuming.