Use Price Channels to Buy, Sell, or Gauge Stock Strength

By Dr. Winton Felt

Traders often construct price channels to help them determine when a stock begins to show weakness.  Channels can give advance warning that the trend is coming to an end.  The channels can also be used to define buy and sell points and to estimate the extent of a move after a breakout in either direction.. 

Before you can construct a channel, you have to construct the basic trendline.  To do so, you would connect two or more peaks for a downtrend.  You would connect two or more trough low points for an uptrend.  If the stock is pulling back, the current price should never be used in constructing a trendline.  For example, if the stock is in an uptrend, the last low that can be used in constructing a trendline must actually qualify as a low.  A low point does not qualify as a low until the stock subsequently rises a significant distance above that low.  Before we define a low as a real low point useful in the construction of a trendline, we want to see three days after the day of that low in which the lowest price of the day is at least ten cents above the high price of the day on which the low was made.  For example, assume that a low of $50 is achieved on March 31st, and that the high price on that day was $51.50.  Before we count $50 as a low useful for constructing a trendline, we want to see three days after March 31st in which the lowest price is at least $51.60. 

To draw a channel, you must draw another line that is parallel to the main trendline.  The parallel line is called the "return trendline," " return line," or "channel line."  Ideally, in an uptrend, it should connect previous highs that occurred just before counter-trend moves brought the stock back to the main trendline.  Draw a broken or dotted line parallel to the main trendline starting from the first major peak that occurred after the starting point of the main trendline.  In a downtrend, you would draw a broken line parallel to the main declining trendline starting from the lowest point of the first trough after the starting point of the main trendline. 

Once you have a defined channel, look for failures of the stock to reach either boundary.  For example, in an up channel, the failure of the stock to reach the upper boundary when it is in the rising part of its cycle signals a possible turning of the trend to the downside.  This gives you a "heads up" to possible trouble even before the lower trendline is broken.  The lower trendline may not actually be broken, but the odds have certainly increased that it will be.  If the stock resumes its climb without reaching the lower line on the declining part of its cycle, it is signaling a possible acceleration of its pace upward.  It may be necessary to create a new and more aggressive trendline.

The "return line" may sometimes be used by traders at stockdisciplines.com to acquire short-term profits by selling when the stock reaches that line.  The main trendline can be used as an entry point when the stock declines to that line.  Of course, some traders would want to see signs that the line is actually giving support before they buy.  That would mean giving up some of the potential gain.  Others would rather trust that the main trendline will give support and place a stop loss just under it in case it does not.  These people would maintain that their method does not give up anything unless their stop loss is actually triggered, and that those who wait for a rebound proof of support are relinquishing some of their gain up front.  Of course, the latter would argue that once they have evidence that the trendline is giving support, their risk is lower and their stop loss is unlikely to be triggered.  These are issues each person must decide for himself.  

Finally, channels can be used to estimate how far a stock will rise after a breakout above the upper boundary of the channel or how much it will likely decline after a breakout below the lower boundary of the channel.  To make the estimate, simply find the distance separating the two lines that define the channel.  If the stock breaks out above the upper boundary, the estimated move can be calculated by adding the distance between the channel boundaries to the upper boundary line at the breakout point.  If the breakout is to the downside, the estimated move can be calculated by subtracting the distance between the channel boundaries from the lower boundary line at the breakout point.