Variations on the Traditional Price Channel

[RichardCox 10]

It can be said that technical analysis in the forex markets is essentially an exercise in framing price activity. Strong skills in this area can help traders to identify exit and entry levels that enhance profitability probabilities, and these framing techniques use historical price activity to determine the possibility of reversal or extension in a given price movement. While these techniques are incapable of predicting the future price of an asset, they can aid in forming expectations in whether or not prices have additional room to extend, or are more likely to reverse. In most cases, traders are looking for indications that one of these scenarios is in place before establishing new positions (or looking to close established positions).

 

Of course, there is a wide variety of methods technical analysts can use to frame price activity, so it is important to test out a few of these approaches in order to determine which feels most comfortable for you. When studying charts, in many situations, it will look as though market values are completely dictated by momentum (or some other force of nature), and that prices can only reverse once this momentum has reached an extreme.

 

Price framing techniques can be one of the best methods for determining when this momentum has reached its extreme points, and when there is an increased likelihood that these formations will result in a bounce or price failure, appropriate entry and exit levels can be identified. When using price channels for these strategies, there are a few different formats that can be applied, and so traders only familiar with the traditional format should take a look at some of the other options to see which format is most suitable. Here, we will look at 3 common approaches to price channel analysis: Trend Line Channels, median-line analysis with Andrew’s Pitchfork Channels, and Donchian Channels.

 

Trend Line Channels

 

Price channels can accomplish different things when traders are attempting to pinpoint continuations in developed trends, or reversals back into an established ranges. Its important to understand the basics, so first we will look at Trend Line Channels. Because of the simplicity involved, some traders might overlook this method of analysis but the fact is that Trend Line Channels can be a highly effective, and can be a very good place to start when traders have limited technical analysis experience. Trend Line Channels are easy to identify and understand, and these can be used in both range bound and trending markets. The central elements are dual trend lines, connecting points of support and resistance, and these channels can come in uptrends, downtrends, and range bound markets. The central visual should be familiar, in the first attachment is an example of an uptrend channel.

 

As a general rule, prices should reach both the upper (resistance) trend line, and the lower (support) line at least two times. Preferably you will see three separate tests, and more is definitely better (improves on the validity of the channel). In rising Trend Line Channels, market momentum is positive and prices are making higher highs along with higher lows. This generally leads to buy entries at channel lows and possible sell exits near the top of the channel. Sell entries are generally not advised in these cases (at channel tops), as the majority of the market momentum is in the upward direction.

 

In declining Trend Line Channels, market momentum is negative and prices are making lower highs along with lower lows. This generally leads to sell entries at channel highs and possible buy exits near the top of the channel. Buy entries are generally not advised in these cases (at channel bottoms), as the majority of the market momentum is in the downward direction.

 

Looking for Price Extremes with Donchian Channels

 

Donchian Channels were created by Richard Donchian in the 1980s, and these studies have had a massive impact on the way markets view channel activity on historical price charts. The main themes center on areas of buying strength and the differences seen in the areas of selling weakness. Donchian Channels are used as a breakout strategy with a high probability outcome, which located areas where prices have surpassed significant highs or lows over a given time frame (which can be individually selected).

 

Donchian Channels tend to give the best signals during market environments with strong trends, weaker results tend to be seen during sideways ranges. The Donchian Channel system looks for trend-following breakouts, and the signals are based on the following criteria:

 

• Prices closing above the Donchian Channel produce buy signals (and indicate areas to close shorts)
  
• Prices closing below the Donchian Channel produce sell signals (and indicate areas to close longs)
  

Trading with Donchian Channels produces relatively few signals but in high probability systems, formations tend to have improved accuracy. In the second attachment, we can see a visual of how Donchian Channels look on a price chart.

 

 

Watching the Median Line with the Andrews Pitchfork

 

Andrews Pitchfork methods tend to fall into the “advanced” category of trading but once we understand the locations trading signals are generated, the tool becomes much easier to use. On the whole, the Andrews Pitchfork system is based on the idea that market values revert to the mean on averaged time frames and divergences from the indicator’s median line will continue until price trends reverse. The main benefit of the Andrews Pitchfork is that it allows for tight stop losses and conservative profit targets.

 

The overall construction of the Andrews Pitchfork is built on market pivots. Three channel lines are drawn (which looks like a pitchfork). A “buy” signal is seen when prices start from the mid point, rise to the upper trend line, and then fall to the lower trend line. The first profit target is the median line, the second profit target is the upper trend line. Stop losses can be placed just below the lower trend line, but the eventual profit target is seen at the upper trend line. A “sell” signal is seen when prices start from the mid point, fall to the lower trend line, and then rise to the upper trend line. Sell entries can be taken here. The first profit target is the median line, the second profit target is the lower trend line. Stop losses can be placed just below the upper trend line.

 

In Andrews Pitchfork analysis most of the arguments rest on the fact that prices gravitate toward the midline 80% of the time when markets are trending. In strongly trending markets, traders tend to target the opposing trendline (for profit targets), and stops can be placed outside the Pitchfork, sometimes using the Average True Range to define extreme areas.

 

Conclusion: Consider All Trend Channel Strategies

 

It is important to remember that trend line strategies can be a highly effective method for determining exit and entry points for chart based trades. In many cases stop losses can be kept tight, which is very helpful in improving risk to reward ratios. Here, we looked at three different formats and traders can choose from the traditional Trend Line Channel, the Donchian Channel and the Andrews Pitchfork, as one of these methods of likely to aid in your individual approach to technical analysis.