Overview of channels – explanation and creation
This lesson will cover the following
- What do they represent?
- Variations of channels
- How to draw a channel
When price action is contained between two lines, a channel is usually formed. A trend channel represents a diagonal channel, where prices oscillate between one trend line and one trend channel line. In the case with a bull channel, it usually has an ascending trend line below (bull trend line) and an ascending trend channel line above (bull trend channel line).
Triangles and wedges as channels
Different types of triangles can also be considered as some sort of channels, as they represent areas, where prices oscillate between two lines. Because triangles demonstrate lower highs (descending triangle), higher lows (ascending triangle) or higher highs and lower lows (symmetrical triangles), we can say that they provide some trending clues, added to their behavior also as trading ranges.
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A symmetrical triangle is an area of price action contained between two diverging lines (trend channel lines). The lower line is drawn across lower lows (so, it is a bear trend channel line), while the upper line is drawn across higher highs (so, it is a bull trend channel line).
An ascending triangle usually has an upper line, acting as a resistance line, and a lower line, acting as a bull trend line.
A descending triangle usually has a lower line, acting as a support line, and an upper line, acting as a bear trend line.
A rising wedge (bull channel) and a falling wedge (bear channel) both have a trend line and a trend channel line, which eventually converge.
Drawing a channel
While a channel is appearing on the chart, traders cannot be sure whether this channel will actually form, or will it more likely be a two-legged price move, followed by a reversal. If prices begin to reverse from a two-legged move, but eventually this reversal fails, so a third leg of movement begins. With this leg initiated, channel lines can now be drawn.
Let us imagine the following situation. Prices have just demonstrated two legs to the upside and have begun to reverse, while many traders probably went short at the reversal. But, if this second leg to the downside ends and seems to be almost of the same size as the first leg down (the one that follows the first leg up), and now a third leg up begins, traders may suppose that a bull channel is forming, rather than a reversal to the downside. When the second leg down is completed, a trader will place a trend line from the low of the first leg down to the low of this second leg and project it to the right. He/she will then attempt to go long once the price returns to the trend line. The trader will also draw a parallel line to the first one and drag it to the peak of the first leg up, thus, forming a channel. Every time the price surges to this trend channel line, the trader will look to take profit on his/her long position and to go short.
On the image below we can see what a bull trend channel should look like.
As a bull channel requires at least the first two legs down, so that the channel itself can be confirmed, and as the price will usually test the area above the peak of the second leg up, bull channels demonstrate at least three swing highs, each higher than the prior one. A trader will not look for a reversal and a breakout from the channel to the downside until the third leg up is completed.
When the trend channel line is overshot (one or more bars manage to penetrate this line) and a huge bear reversal bar appears on the chart, most traders will begin to short heavily. That is so, because they see a greater probability that a breakout to the downside may occur. That is also a possible reason why many bull channels end after a third swing high is reached. Respectively, many bear channels end after a third swing low is reached.