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Trading Within a Channel in Price Action Terms

Trading within a channel

This lesson will cover the following

  • How do experienced traders usually trade a channel?
  • How should beginners trade a channel?
  • A conventional trading scenario
  • Another trading approach

More experienced traders trade in the direction of the trend, but not necessarily

more experiencedIn case a trader spots the beginning of a channel, he/she will usually enter into positions in the direction of the trend. But, as the price approaches a key level within the channel and trading appears to be more two-sided, more experienced traders will begin entering into countertrend trades. As a rule, in the beginning of the channel, it is appropriate to go long below the low prices of bars. With prices progressing toward the resistance zone of the channel and with the appearance of overlapping bars, larger pullbacks and bear trend bars, many traders will look to go short above the bars, than to go long below them.

Exclamation-mark-iconIn a bull channel, traders with not consistent gains, should abstain from making entries on short signals. Even if there may be acceptable signals, traders should not look to go short, because the market is always-in long (any time traders are forced to decide between going long or going short, they feel more confident in long positions, thus, the market is always-in long at that moment. A sudden move in the direction of the trend is to be witnessed, however, before traders can gain such confidence.)

In order for them to go short, the market needs to be plainly always-in short. This will require a sharp bearish price move, which goes below the channel and is followed by more price action.

Beginners should always trade in the direction of the trend, if at all

beginnersWithin a channel beginner traders, on the other hand, should enter only in the direction of the trend. As all channels attempt to reverse and a large number of pullbacks occurs, beginners may register losses repeatedly. If they spot a bull channel developing, they should look only to go long. Within a channel traders with no experience would better wait for the most distinct setups to appear, even if the whole trend may be missed.

A conventional trading scenario

WonderAs channels usually extend further than what the majority of market participants anticipate, in a bull channel the uptrend usually exceeds the first one or more apparent resistance levels and reaches another resistance, where a sufficient number of institutional buyers and sellers are convinced that the price has climbed enough and is not likely to continue up. At such a level the buying pressure eventually ceases. Institutional bulls take their profits (selling their long positions), while institutional bears enter the market and begin selling heavily. This may lead to a large retracement or even to a reversal into an opposite trend.

The uptrend ends in the form of a breakout of the upper area of the channel, where bears with limited capacity desperately buy back their short positions, while bulls with limited capacity, looking for a lower price, finally enter into a long position.

Institutional bears will usually wait for the sudden breakout and then begin selling heavily, as they suppose this is a short-lived chance to sell at a quite high price level. A short-lived chance, because the price will not likely remain that high for long.

Institutional bulls will close their long positions after the sudden move up has occurred. They are not to go long again until the price returns to the beginning of the channel, a level where they originally entered into their profitable trade. Institutional bears are aware of this, so they will need to take their profits and exit precisely where the institutional bulls are intending to buy again. This leads to a rebound, which is usually followed by a trading range. It is so, as both sides are now unaware what the markets next move is going to be. If there is a trading range, there usually is uncertainty in the market.

Another trading approach

Muscles-iconStrong (institutional) bears may consider another approach, as the channel continues to develop up. They may prefer to sell as prices rise (scaling in their positions), because they suppose that the movement to the upside may be limited. As these strong bears continue to sell, this boosts selling pressure in the market. A greater number of bars with bear bodies, bars with upper wicks and bars with low prices below the low price of the preceding bar begin to appear on the chart. These bears expect a breakout of the channel to the downside and even prices to return to the beginning of the channel itself.

Instead of waiting for a reversal to occur, these strong bears continue selling as the bull channel develops. This is so, because they look for an opportunity to go short at the best possible price. The reversal may happen to be rapid and strong and they may find themselves going short quite far below the upper area of the channel than they assume is likely to be profitable.

They are likely to scale in their positions in some of the following ways – to place a limit order to sell above the high price of the preceding bar, to go short above a minor swing high in the channel, or at any test of the trend channel line (upper line). Once prices reverse their direction, these bears may hold the entire position, if they anticipate a huge reversal, or they may exit the market at their profit target (a test at the trend line of the channel). Their exit may also be at the entry price of their first short position – close to the beginning of the channel.

In a bull channel such a strategy, however, is appropriate only during the first two thirds of the trading day. Or, if one is to trade within a channel during the second half of the day, he/she would better enter only in the direction of the trend (to go short below the low price of the preceding bar).

If prices continue their move up higher than what these bears expected, they will be forced to close (buy back) their entire positions at a loss. In such a case, a climactic breakout to the upside will occur at the end of the channel. These traders do not expect a pullback to occur soon (something which would enable them to buy back at a better price, so they prefer to close all their short positions at a loss. Many of these bears are momentum traders, so they will probably enter into long positions immediately. All bulls that trade on momentum will continue going long, while prices surge. They believe they have an advantage, because the chance of the following pip being higher instead of lower is over 50%. As soon as the momentum is over, both sides will exit their long positions.