Posted by: Livy | February 12, 2009

Channels

Support, Resistance, and Breakouts: Drawing Channels

Creating channels on your chart, either by hand or with software using MA envelopes or Bollinger Bands, is a useful tool at identifying entry and exit points. Channels also can indicate bullish, bearish, and continuation trends, as well as gives the trader an idea to the recent volatility of the price. Many traders master this art and live by it. Each trader defines his or her own rules, but there are some general guidelines from which to start from, and the intent here is to educate you on those guidelines.

When drawing a support or a resistance line, you want to hit three, let me say that again, THREE highs or lows. Two is to unreliable. I say this before I even explain what they are because it is important. Equally important is the confirmation. Each additional time a price bar touches your support or resistance line, but doesn’t cross it (breakout) your line is confirmed. If you understand these points alone, you probably can begin drawing channels, but a deeper understanding of channels, and what the patterns they create represent, will make you a more successful trader. Finally, DO redraw your channels frequently over time. Redraw them to the point of being obsessive.

Support
Support is the lower price in which a security garnishes strong buying power. A valid and confirmed support line, assuming the current trend continues, is essentially as low as a price will go without any change in market sentiment or news that will adjust a trend. You create a support line by drawing a line through three bottom lows and extend it into the future.  You now have a support, a price in which, as long as the security acts in the same manner, a particular security should not drop below.

Resistance
The opposite of support. It’s the price ceiling in which selling pressure becomes significant. Many traders view a breakout upward of the resistance line as a buy indicator. The idea being that a new resistance is going to occur at a higher price.

When both the resistance and the support line are drawn, you have a channel.

Breakout
A breakout is when the price bar raises above or below the channel that has been created. If the channel is strong, and has been confirmed and tested many times by the price of a security, odds are strong that a trend reversal is occurring. Many traders wait for more than one price bar to determine a true breakout, rather than acting on what may be a false breakout. Prices do fluctuate, and market sentiment or news may temporarily push a price bar outside of your channel. Trading is not an exact science, it is up to you to determine if it’s a true breakout or a false breakout. If you make a mistake see if you can determine why, it may make future channels stronger and can give you insight to the behavior of that particular stock.
channelMathematical Channels (Upper Indicators)
There are a number of overlays that can be put on a stock chart. Most charting software refers to them as “upper indicators” Many ‘newbies’ try to use too many and their stock charts look more like engineering blue prints than they do stock charts. Find and choose one that fits your style and provides you with the best results. Only a few of the more popular ones are covered here.

MA Envelopes
This simply takes a moving average and adds channel lines in a user defined percentage of deviation, often 1-7%. A security could spend months outside of the MA envelope.

MABollinger Bands
The Bollinger Band is very popular. It uses a 15 day moving average for the center line, with a support and resistance line taken statistically at two standard deviations. 95% of the price fluctuations will occur within the channel. The bands are not signals, they are tags. The inventor himself strongly suggests using a momentum indicator along with this. You can see the dotted MA line along with the outside bands in the chart below.
BollingerKeltner Channels
While not among the more popular channels, this indicator utilizes a moving average with a band above and below it, much like a Bollinger Band. It takes the high, low, and closing price for the moving average. The bands that are formed are figured from the daily high minus the daily low over a period of 10 days. The creator suggests selling when a price bar breaks the upper band and buying when it drops below the lower band.
Keltner

Parabolic SAR
Developed by the same person that brought us the Relative Strength Indicator (RSI) this channel is used to establish trailing stops. The bottom line is used for long position and the top line is used for short selling. Establish a trend and then follow it. If the price is trending in a bullish pattern buy when the indicator moves below the price and vice versa. You’ll quickly notice that the channel only indicates above the stock in a downtrend and only below the stock in an uptrend.
Parabolic SAR

Channel and Line Patterns
The shapes that a channel creates, such as a flag, as well as the path the line creates, can be used as indicators. Some are powerful and have very high levels of reliability, others simply point to a bearish or bullish sentiment in the stock price.

Price Channel
Essentially what we have already covered. The example above is a bullish price channel because it has an upward slope. A bearish price channel would have a downward slope, and a continuation price channel would be flat. In reality, all price channels that have even lines are continuation patterns and unless a breakout occurs, the trend should continue and the stock price will behave in the same that it has been.

Pennant (Triangle) and Flag
Both the pennant and flag are very similar. A good resource for learning how to trade this type of pattern can be found at:

http://hubpages.com/hub/How-to-Trade-the-Flag-and-Pennant-Chart-Patterns-Video

Pennant
This channel shape indicates a continuation. The price channel becomes more narrow as time goes on. This is typically done with a lower price range between the high and the low, showing the trader that the market is confident that the security is accurately priced and very little struggle between the bulls and the bears.

Flag
The flag shape is a bullish or a bearish price channel. It is a price ‘pullback’, sort of a hiccup in a trend. It rarely lasts longer than two weeks and has to be preceded by a large amount of volume. When the flag has run it’s course, the trend will continue, meaning that the flag is also a continuation pattern even though it moves in the opposite directions of the trend.

Double Bottom (Reverse Head and Shoulders)
This is my favorite bullish reversal pattern. This occurs when the price line creates a “W” shape. It has gone down and tested the support twice and when it goes up, it usually goes up big.  There are some requirements for this to occur. The two lows need to be close to each other in terms of price (3-5%) and far from each other in terms of time (10-45 trading days).  Once the upswing passes the middle hump, and it meets the other criteria, we have ourselves a double bottom. Most successful advisors suggest you buy in when it gets confirmed on the way back up, not before. Also, trading this can be hard, as price retracements occur shortly after the confirmation as day traders, etc take their profits and run. These retracements can test your will.
Double Bottom

Head and Shoulders (Double Top)
Fairly close to the opposite of the double bottom, this bearish indicator shows three points rather than two, making it even stronger. The confirmation in the head and shoulders is a line drawn between the two low points in between the head. This is usually seen after a long uptrend and is characteristic of testing new highs and price retracements. If you are long on a position get the heck out! This is a great opportunity to short a position however.
Head and Shoulders

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