Trading the channel phase of spike plus channel trends
This lesson will cover the following
- Projecting a channel
- Different trading approaches
- Signs of weakness in a channel
In case a huge move is present, followed by a pullback of even one single bar, after which a resumption of the trend is to be seen, there is a good probability of a spike plus channel trend. Let us provide an explanation of a similar situation. A trader sees a sudden move to the upside, which breaches a trading range. Next, an inside bar forms, followed by a bar, that moves below this inside bar. Eventually, the second bar reverses up (transforms into a bull reversal bar), while many traders will be waiting to enter long above the high of this bar, because they expect a bull channel. With prices moving above this bars high, the bull channel is already apparent.
In case this bull channel extends to an area, where a possible reversal can occur (a top of a trading range), it may indeed reverse after several legs up.
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In case the bull channel develops in an area, where an uptrend is possible (an upward reversal after a clear bottom pattern), the channel may form at least three swing highs.
Projecting the channel
During a strong trend a channel may progress much further than what most traders anticipate. In case of a huge spike, a possible measured target can be the distance between the open or low price of the first bar of the spike itself to the close or high price of the last bar of the spike. That distance needs to be projected up. Then, a trader should look to determine whether a reversal is setting up, after the channel has reached the measured target.
A trader may spot other measured target projections, but the majority of them will likely fail, if the trend is particularly strong. These targets are important, because when a reversal sets up eventually, this will happen at one of these resistances, which provide a trader with the comfort to actually take the reversal trade. However, we have already said in our previous guide that measured targets are more appropriate in order to lock in gains, than to look for entry points in reversal trades. Usually traders will consider a reversal trade only when they see a strong setup. Traders with formidable experience may consider to scalp against the underlying trend at measured targets and even scale in, in case prices move in the opposite direction to theirs. However, it is a risky move and there is no guarantee that it will turn out to be profitable.
Countertrend trades are good with-trend setups
After a trader has identified the spike plus channel trend, it is not recommended to enter against the trend on anticipation that the ABC pullback will reach far enough in order to ensure a scalpers gain. There might probably not have been a breach of a prior trend line and also the channel may be too tight, which renders a trade against the trend unsuccessful. We can say that these countertrend scalps offer good with-trend opportunities. The entry should be on a stop, where countertrend traders exit the market with protective stops.
Traders, using a more aggressive approach, may enter channels on limit orders and in the direction of the trend until indications of two-sided trading appear. When this happens, most of these traders may begin entering against the trend.
Let us have the following situation. A huge bearish move occurs, followed by a channel. Sellers will probably enter the market on limit orders at or above high prices of previous bars. With the bear channel moving closer to support levels, sellers will probably examine whether large overlap between bars is present, whether more considerable bull trend bars and more doji bars appear, whether larger pullbacks are to be seen. If more of these indications of two-sided trading are present, buyers will probably grow more anxious to go long on limit orders at or below low prices of previous bars and swing lows. Sellers, on the other hand, will probably scale out of profitable trades after the trend has continued for some time and especially if it is in the area of support levels and measured targets. Buyers will probably consider scaling in their long positions in that same area. As a result of this boosted buying and weakened selling a breakout from the bear trend line finally occurs.
Institutional traders and individual traders with large capacity can afford to scale in a position against the trend, anticipating that prices may test the beginning of the channel. However, most traders prefer to trade in the direction of the trend until they detect plain indications that a reversal is imminent.
Sometimes channels tend to be parabolic
At times channels appear to be quite vertical and as they accelerate, they tend to be of more parabolic shape. In this case little overlap between successive bars is present and the channel does not appear as a typical one. The parabolic move actually represents the channel phase of the trend. The move itself may, in many cases, include a huge trend bar.
Let us have the following situation. A sudden bearish move of one or more huge bear trend bars occurs, followed by a pause and after that another bear spike appears. This is a situation of two successive sell climaxes. In case two successive climaxes, separated by a pause or a pullback, occur, these are usually followed by a two-legged retracement. The latter usually tests the pause, which comes after the first climax. The second climax may be considered as the channel phase of the spike plus channel formation, regardless of the fact that it is simply another sudden move (spike) and not a channel, where prices demonstrate lower momentum. Thus, successive climaxes can be considered as a version of traditional spike plus channel trends. In rare cases a third successive climax can be observed.
Signs of weakness in a channel
In case there is large overlap between adjacent bars, a large number of trend bars in the opposite direction and a few pullbacks comprised by several bars, this all points to a weakness in the channel itself. The weaker one channel is, the more expansive institutional countertrend traders will probably be.
In a weak bear channel, following a bearish spike, institutional bulls will probably be more anxious to scale in their longs, as the price continues to fall. This includes going long below the low price of every bar or below the low price of the previous swing low, or on every test of the trend channel line. If the price sharply breaks out from the bottom of the channel, instead from the top, and a huge bear spike of several bars appears, these strong bulls will need to close their positions. They sell their longs, thus, this contributes to the strength of the bearish move. Since most of them are momentum traders, they will probably switch to short positions.
This breakout to the downside, on the other hand, may not extend quite much. As soon as the most unsuccessful bulls manage to sell their long positions, there will probably be no one considering to go short at levels that low. Therefore, the market will likely demonstrate a rally for at least two legs and over ten bars, looking for a higher price level, where bears may consider to go short again.