Last Updated on 17 November, 2020 by Samuelsson
In trading, there are some technical tools that quite some traders can’t do with. One such tool is price channels.
Price channels basically are two lines that are drawn above and below the price of the security, forming a channel. Price channels are some of the most commonly used tools in trading, and come in many forms and shapes, with trend lines being the most popular alternative.
In this guide, we’ll look at the most common price channel types, how they work, and which one may suit you best. In addition, we’ll also take a look at some common trading strategies involving price channels.
Let’s start off by getting to know the four most common price channel types!
Upon entering the world of trading, it doesn’t take long to stumble upon the concept of trend lines.
In short, trend lines connect tops with tops, and bottoms with bottoms, to form lines. And when there are two lines that run parallel to each other, we usually say that there is a trend channel.
Below you see an example of a trend channel.
As you see, the lower and upper trend lines run nearly in parallel, marking out a corridor that the market has stayed in for quite some time.
However, as we see to the right in the image, the market then breaks above the upper trend line. This is a common scenario, and most trend channels aren’t that long-lived, but must be redrawn continuously to account for new market developments.
Types of Trend Channels
The direction of the trend channel to a large extent shows us the sentiment in the market To make it easy, you could start off by dividing them into three categories:
- Flat channels: These channels occur when both trend lines are flat and flat. In other words, the market sentiment is neutral, and neither bullish nor bearish forces prevail at the moment.
- Ascending channel: With an ascending channel, we’re told that the market sentiment is bullish since market participants manage to push the bottoms and tops higher and higher.
- Descending channel: As you might expect, a descending channel instead incorporates two down sloping trend lines, and suggest that the market is bearish. After all, sellers constantly make sure that bottoms and tops return at lower levels.
Then to take it one step further, you could start to look at convergences and divergences between the upper and lower trend line.
For instance, an ascending trend channel where the upper trend line moves closer and closer to the lower trend line, suggests that the market may not be as bullish as it seems. After all, bulls don’t seem to have the power to make the tops ascend at the same pace at the bottoms.
Below is an example of this. The lower trend line is advancing much faster than the upper trend line. However, in this case, it did end in a bullish manner, which some people would say was expected, since it, in fact, resembles an ascending triangle.
The Donchian channel is a trading indicator that was invented by Richard Donchian, who by many is considered the father of trend following. As such, it comes as no surprise that it’s one of the most widely used price channel indicators by traders who rely on trend following strategies to pick their entries.
To keep it concise, the indicator consists of three lines. The two outer lines mark the highest high and the lowest low for the period, which usually is 20 days. Then, the third band in between is a plain average of the two outer bands.
In other words:
Upper line: the highest high for the last n-periods.
Middle line: the average of the upper and lower line
Lower line: the lowest low for the last n-periods
What Are Donchian Channels Used For?
The most common application of Donchian channels is to look for breakouts above the upper line or below the lower line. This also was the original intent of Richard Donchian, as he invented the indicator back in the 50s.
However, this approach is very prone to false breakouts, since the market constantly will break previous highs and lows only to fall back shortly thereafter.
Those who want to learn more about the indicator may head over to our big article on Donchian Channels to find out more.
If you don’t know the difference between Keltner channels and Donchian channels, they may appear to be quite similar. However, there are some significant differences between the two.
Firstly, the middle band of the Keltner channel is not derived from the upper and lower band. Instead, the middle band is an exponential moving average, from which the upper and lower bands are calculated.
Secondly, the Keltner channel has the upper and lower bands placed at the same distance from the middle band with the distance being calculated as a multiple of Average True Range
In that sense, the Keltner channel indicator is more complex as it also takes the volatility of the market into account through the use of the ATR.
How is the Keltner Channel Indicator Used?
In many regards, the Keltner channel indicator is used in the same way as donchian channels. That is, a breakout above the upper line may suggest that there is a strong trend worth buying on.
However, another common usage is to consider moves below the lower line as a sign of an oversold market, that’s worth buying on. That’s especially the case in market that tend to mean revert a lot, such as stocks and equities in general.
Those who want to learn more about the indicator should definitely head over to our big guide to Keltner channels.
The last price channel type we wanted to bring up in this guide, is the Bollinger bands indicator. Invented by John Bollinger in the early 1980s, it took the principles of the already invented price channel indicators to a new level, by introducing a measure of standard deviation into the formula.
How to Use Price Channels
So far throughout the guide we have briefly touched on the common ways that traders make use of trading channels to find profitable entries. However, there is a lot more to say on the topic.
That’s why we’ll devote this section of the article to how you could go about to use price channels in your trading. We’ll have a look at mean reversion trading, breakout trading, as well as trend following, and discuss how price channels can play a role in defining profitable trading setups for all these trading styles.
In addition you’ll learn a couple of techniques to improve the accuracy of a trading system.
Let’s begin right away with the trading style that associated with price channels, namely trend following.
As we mentioned at the beginning of the article, some of the earliest trend channels mostly served to provide trend followers with entry signals. In short, they wanted to know when the market was likely to establish a new trend, in order to ride it for as long as possible.
The most common approach is to wait for the market to approach the upper band to go long, and the lower band to go show. The rationale is that a market that manages to break out of the price channel is strong enough to continue in the direction of the breakout.
Below you see a couple of examples of how the market established a new trend direction shortly after having gone above or below the outer bands.
What Price Channels Work Best With Trend Following
While we still encourage you to do your own testing to see what works best in your particular case, we do have some things to add when it comes to trend following.
In our experience, levels in price that are derived from specific price points, like the close or high of a bar, tend to work more often than those that are derived through some type of mathematical formula.
So, this would speak in favor of the Donchian channel, which bases the channel lines on the high and low of the recent period.
Now, regardless of what our experience has been, we do still recommend that you use backtesting to determine what seems to work well for you. In addition, it pays to remind you that there still are a lot of great strategies that rely on the Keltner and Bollinger bands. It´s just that you get so many variables with the introduction of moving averages and mathematical formulas, that it may be hard to see the forest for the trees.
The Issue With False Signals
Now, one of the biggest disadvantages with the trend following approach is that there will be a lot of false signals. The market simply will touch the outer bands many times, only to recede shortly thereafter.
This means that trend followers tend to have quite few winning trades, which is compensated by some few big winners. It isn´t strange to have as few as 20% winners for a trend following strategy that still remains profitable.
Later in the article, we´ll introduce you to a couple of techniques that you can use to improve the accuracy of trades when trading with price channels.
Another common application of price channels is in breakout trading.
Now, breakout trading and trend following are quite similar. They both act on a break above or below a significant level, such as a price channel. However, if you were to make any distinction, you could say that breakout trades usually don´t last as long as trend-following trades.
Another difference is that breakout trading is quite common on intraday and even daytrading systems, while trend following tends to be reserved mostly for the daily timeframe.
We won´t go much deeper into breakout trading in this article, but if you´re interested in knowing more, you may check out our complete guide to breakout trading! There we’ll cover breakout trading and a lot of surrounding topics that you may like to know!
Mean Reversion Trading With Price Channels
With breakout trading and trend following being concepts that act on trend strength, it’s time to move on to mean reversion, which capitalizes on the very opposite tendency!
In short, mean reversion is the tendency of some markets to produce outsize moves in either direction, which are then compensated by a move in the opposite direction. So if the market has gone down too much, we usually tend to get a quite powerful upmove, which we define as a reversion to the mean.
So how can price channels be used to define oversold and overbought levels?
Well, it’s quite easy. As soon as the market hits the lower line, it’s oversold, and when it hits the upper band, it’s oversold.
That is, we want to buy when the price hits the lower band, and go short when it hits the upper band, like in the example below
Now, mean reversion tends to work best in the equity markets such as stocks. And since the equity markets have a long term bullish bias, you’ll find that going long works much better than going short.
That’s also what we recommend that you focus on at the beginning if you’re into trading stocks.
What Price Channels Work Best With Mean Reversion
Earlier in the article, we expressed a view that price channels like Donchian channels tend to work well in trend following, since the outer bands represent specific levels price levels, rather than some mathematical formula.
Now, we wouldn’t say that this applies as much to mean reversion. This is because the thing that really counts in mean reversion is how oversold the market has become, and maybe not as much the specific price levels.
Thus, you may find that the price channels like Bollinger bands actually have an advantage, since the bands may be placed quite far from the price. In addition, the distance is based on the current market volatility, which means that the oversold and overbought levels adapt to the current market state and might be more reliable!
Does the market always revert around the lower line?
The short answer to this is no. Many times you’ll see the market continue falling as it approaches the lower line of your chosen price channel indicator.
In these cases, it’s important to remember that the more the market falls, the better the edge fets. This is the reason why those who trade swing trading strategies use to have very wide stop losses. They simply don’t want to get stopped out too often, since it would mean exiting a trade when the edge is at its strongest.
If you’re looking into mean reversion trading, we really recommend that you keep your stop loss wide and expect that some stocks may continue down for quite some time, before they finally revert!
Techniques To Improve a Trading Strategy
Having covered the most common trading methods involving price channels, we’ll now move on to some techniques that you use to enhance the performance of a trading strategy. This will come handy regardless of the trading style that you’re pursing, since most trading strategies that rely on price channels only will need some further filtering to be worth trading.
So, here are three methods that you could use to improve the performance of price channel trading strategies:
1.Use RSI for Mean Reversion Strategies
The typical approach to mean reversion trading with price channels is to simply take a trade as the market goes below the lower band. However, while this may indicate that the market has become overbought, we often need to impose more conditions to ensure that we have a real edge.
This is where oscillating trading indicators, like the RSI or Stochastic, could help a lot. When these show very low values, especially if you have set the period to 6 or lower, there usually exists quite a good edge. Thus, you may combine these low readings with a crossover below the lower price channel band to enhance your signals.
Below you see how the market goes below the lower bollinger band, while the 2-period RSI is below 10.
2. Use ADX (for mean reversion and trend following strategies
The ADX indicator is one of our favorite trading indicators, and can be used in a lot of different scenarios.
In short, ADX measures the strength of the trend, where readings above 25 suggest that the trend is strong, while readings below 20 show that the market is rather calm.
In this guide to price channels, we’ve briefly covered the most common price channels and how you may use them for your trading.
However, always remember that you should never try to trade a trading strategy without some sort of validation. To learn more about how to validate a trading strategy, we recommend that you have a look at our guide to backtesting, or our article that covers how to build a trading strategy.