Overview of channels – the vacuum effect
This lesson will cover the following
- Explanation of the vacuum effect
- What actions do strong participants in the market actually take?
- Trend channels as sloping trading ranges
Within a channel prices oscillate between the upper and the lower area of this channel due to the so called vacuum effect. Let us imagine a bull channel. Prices are in a leg, which tends to approach the trend channel line (upper line). As traders suppose that the price may touch this line and may even exceed it, they will prefer to hold back on their short positions. Buyers will look to exit their long positions and take profits, while sellers will look to enter into new short positions. So, this relative absence of selling in the market triggers an imbalance and, as with any imbalance, prices tend to move more rapidly.
A huge bull trend bar often is formed, as the price tests the upper area of the channel. This may lure anxious bulls to go long at the top of the sudden move, because they assume that the price is creating a stronger leg up. However, as the majority of breakout attempts tend to fail, this move may be a failure too, because of the presence of institutional participants. Bears with huge capacity intend to go short, but they will probably wait until prices touch the trend channel line (upper line). As soon as the price reaches that level, they begin to sell excessively, thus, they overpower the bulls. Institutional bears prefer to detect a large bull trend bar. That is so, because as they assume that prices will fall, they will place their sell orders at the best possible spot, the top of that large bull trend bar.
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The price may halt in the upper area of the channel, because both sides of the market will be deciding whether an actual breakout of the channel will happen. After that the price will usually tumble rapidly, because both strong (institutional) bulls and bears have probably become aware of the great probability that the breakout attempt may be a failure.
What actions do these strong participants actually take?
In the upper area of the channel, strong bulls quit their buying and close their long positions for a brief profit. They are aware that such an opportunity will be short-lived, as the market tends not to remain at an extreme level for long. As these bulls exit the market, they will probably not go long for a few bars.
A relative absence of buying is now present. At the same time, strong bears begin to sell heavily, which causes the price to rapidly plunge to the lower area of the channel. Both sides now anticipate that the trend line (lower line) will be tested. Strong bears will continue to go short until the price actually reaches the trend line and they will probably take their profits there. In the mean time, strong bulls will probably abstain from action until the price actually touches the trend line.
Such a situation will lead to a quick sharp move to the downside, which may urge beginner traders to go short, as they may probably expect a breakout below the trend line. Now you understand that they intend to act in the exactly opposite way compared to that of institutional players. So, beginners should take note, that their major goal is to follow the actions of these institutional traders and never take the opposite action.
As the price enters the lower area of the channel and eventually touches the trend line, strong bulls will enter into new long positions, while strong bears will take profits on their short positions. Both sides now anticipate that the price may form a new high and test the upper area of the channel. There the whole process will begin once again. Such a process is valid for all channels – from trading ranges to triangles.
Trend channels as sloping trading ranges
Within a trend channel two-sided trading actually occurs, which provides a reason to perceive this as a behavior inherent to trading ranges. Every trend channel can be viewed as a trading range with a slope. In case this slope has considerable steepness and the channel itself seems to be narrow, the same channel has a trending behavior. So, traders should make their entries only in the direction of the underlying trend.
In case the slope has lesser steepness and the price has demonstrated larger swings within the channel itself (for instance, over five bars), we can say this very channel behaves more like a trading range. So, traders are able to make entries in either direction.
On the image below we can see what a bear trend channel should look like.
There seems to be some kind of a magnetic pull in the middle area of the channel, which manages to contain price action into this channel. This is something typical for all trading ranges. Prices remain in the channel and do not demonstrate a sharp acceleration, because of the high level of uncertainty, just like the case with all trading ranges.
If we are to imagine again a bull channel, the bulls will be looking to bolster their positions at the lowest possible price. Bears with limited capacity, on the other hand, will hope a sell-off to be present so that they can exit at the smallest possible loss. As the bulls are not certain whether a pullback, that will allow them to buy as much as they intend to at a better price, will actually occur, they will probably continue to purchase at stages, as the price surges. Meanwhile, bears with limited capacity will look to buy back their losing shorts. Such a scenario will surely bolster buying pressure in the market.