A price channel appears on a chart when a security’s price becomes bounded between two parallel lines. Depending on the direction of the trend, the channel may be termed horizontal, ascending, or descending. Price channels are often used by traders, who practice the art of technical analysis, to gauge the momentum and direction of a security’s price action and to identify trading channels. Although the price channel can vary in different directions, the main signal it is giving actually stems from how the prices move within the channels. This crucial hint the price channel provides insight to the market and allows traders to stay one step ahead of others. On top of that the boundaries provided by price channels also allow traders to predict the reversal of prices at a specific point in the market.
Price channels explained
The price channel though might not be a good tool for trading on its own, it can definitely provide insightful information on the market, especially when the market is in side ways consolidation. With that being said, there are two primary uses for price channels to gain such information on the market.
Firstly, the price channel can be used as “pivot points” to predict when prices are about to reverse. This is of course assuming that market sentiment is perfect, and a hundred percent accurate channel has been plotted. As prices are bounded by the price channel, it is safe to say that every time prices were to test the roof or the floor of the price channel, it will bounce and reverse to test the other. This will keep happening until prices breakout or loses momentum to test one of the two. More often than not, the latter would also mean that a breakout is prominent.
Secondly, the price channel is able to predict the breakout direction via the momentum of the price action. As prices consolidates and bounces in between the boundaries of the channel, the prices are bound to lose momentum in a certain direction at some point. As such this decrease in momentum can be observed within the price channel. As momentum is decreasing, prices will be unable to test one end of the price channel, causing the formation of higher lows or lower highs. The formation of lower highs and higher lows also signify that the opposing momentum and volume is increasing, causing a breakout in the direction of higher momentum and volume.
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How to use
Other than providing information, price channels can be used to trade as well. There are typically two ways of trading, the first being trading within the channel and the second being trading the breakout of the price channel. For this article, we will be testing the latter in our analysis. For the price channel trading strategy, the entry can be taken at the high or low of the breakout candle. As for the stoploss order, it can be determined by placing it at half the vertical width of the channel in terms of pips. Lastly, the profit taking order can be determined by the full vertical width of the price channel projected from the point of break out.
Pros and cons
The pros of using the price channel trading strategy are that it there is a high rate of occurrence in the market regardless of timeframes. Other than that, it gives traders valuable information of the market, allowing them to predict turning points within the channel and also the momentum and volume of prices inside of the channels, preparing them better for a breakout. However, this strategy will be prone to fake outs. Thus, it is important to be patient and wait for candles to close before carrying out any trade actions. In addition, it though it can gauge when prices are going for a breakout, it is unable to gauge the strength of the break out.
To find out the profitability of the Price Channel trading strategy, we decided to do a back test based on the past 10 trades from 27 May 21 on the H4 timeframe. The rules for entry will be the same as what was mentioned above. We will be back testing this throughout 3 types of trading vehicles, namely, EURUSD for forex, AAPL for stocks and BTCUSD for cryptocurrency. For simplicity, we will assume that all trades taken have a risk of 1% of the account.
Definitions: Avg Risk reward ratio= ( Total risk reward ratio of winning trades/ total no. of wins)
Profitability (% gain)= (no. of wins* reward)- (no of losses* 1) [ Risk is 1%]
An example of the application of the strategy:
For the Backtest results, trades with blue and yellow zones indicate an overall win with the blue zone as reward and the yellow zone as the risk taken.
As shown in our backtest, the win rate of this strategy for EURUSD (Forex) is 40%, AAPL (Stocks) is 20% and BTC (Crypto) is 50%
The average risk reward ratio of this strategy for EURUSD (Forex) is 1.23, AAPL (Stocks) is 1.7 and BTC (Crypto) is 1.07.
The profitability of this strategy for EURUSD (Forex) is -2.94, AAPL (Stocks) is -8.4 and BTC (Crypto) is 0.37.
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In conclusion, the price channel is a supportive strategy and not one purely for trading when used on its own. This is evident from the analysis statistics that portrays it to be a trading strategy of poor win rate, risk reward ratio and profitability. However, it will be an even better strategy when used together with breakout strength predicting indicators as well as momentum and volume indicators that help to better determine and segregate the false breakouts from the real breakouts. Subsequently price action is also a key factor for trading it as it improves the win rate be it trading a breakout or within the price channel.
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