Price Channels–The Hidden Gem of Breakouts

Whether you want to clean up your charts, want a better way to determine when to trade certain setups, or are simply looking for a quicker one look option, price channels can provide an excellent addition to your charts.  We talked about this in indicators 101, every single part of your charts must have a purpose.  If you can’t completely explain why the indicator is on there, take it off.  Hopefully, by the time this article is over, you will have no doubt in your mind why price channels could be in your trading arsenal.

The picture shown on the blog was SPY which was called long mid 17′ at 245.01 on the break.  Notice how on a 3% stop you’d now be up over 10% simply trading a general market breakout?  That is the power of using price channels the right way.  If you want to learn more, let’s get started.

This is SQ.  It’s clearly been a beast in 2017.  However, this wasn’t the first time it tried to be such a beast.  What about in April 2016 when it made new ATH yet it fails shortly after.  How come SQ can’t do then what it does now?  Part of the answer at least, was shown in the price channels.

All technical analysis ignores fundamentals.  We have to understand this going in because there may be a solid fundamental reason why SQ shifted in 2017 to allow such a move, whether general market or stock specific.  Regardless, for this example, we are only focusing on this indicator.  Whatever other reasons present for SQ are simply not important for our technical view.

To look at the results of SQ and ultimately price channels, we really just need to remember these 5 rules.

Rule #1. Price Channels work best on Higher Timeframes.

This means if you’re unsure, get to a higher timeframe.  If considering a daily trade using these channels and you can’t tell, move to the weekly.  If using a 15 minute trade, move to the 60. 

If you can see a breakout on your timeframe but see a potental floor or lid against you on a slightly higher timeframe, the odds of a successful break go down significantly.  Put another way, when in doutbt, zoom out.

Rule #2. Price Channels work Best after a Rest.

Let’s go back to our SQ example.  Notice in April 2016 when price makes a new 20 range high but it can’t get past that and ultimately rolls over.  Now take a look at 2017.  Price makes a new 20 range high on the weekly chart, which is also an All Time High (ATH), and then rests.

The difference is this time price pulls back slightly and holds above the old 20 range high.  After it’s held for a few weeks to months, price starts to move back up.  It has now had a long enough rest after the initial move to continue when it ultimately breaks out.

This also allows you to put your stop below the pivot low of the rest vs the pivot low of the entire move.  Notice the profit difference this makes when your total risk goes from $5 down to $2.50.  All these advantages simply come when the price channels go sideways and you see a potential rest spot.  Getting in after this rest can produce significant returns.

Rule #3. Decide if you're intrabar or closed bar now, not later.

This is a personal question.  Let’s go back to our SQ setup.  Notice the old 20 range high in early 2017.  Now notice the weekly bar that closes just past that range high.  That is the perfect signal.  Seeing this weekly bar close on friday allows you to get in on monday at the start of a new bar with a tight stop and an outsized return.  Great Job.

Now lets’s look at the other side of the coin.  What if the signal bar gets past that high on monday but you’re trading a closed bar.  You’re another 4 trading days before this weekly bar closes and you could miss the entire thing.  Are you willing to trust this and let it play out or do you see a great setup and decide it’s foolish to wait?  When using price channels for breakouts, you have to decide before you start whether it’s a closed candle, intrabar, or both.  The only wrong answer is not deciding until FOMO (Fear of Missing Out) takes over.  Some will not stop and you’ll miss out, others will trigger and pullback and fake you out, there’s no right or wrong answer, as long as you pick an answer.

Rule #4. Watch for Polarity with Price Channels.

Polarity is when support becomes resistance or resistance becomes support.  Notice when price broke out past the 2016 high, it quickly retraces back into that area and holds.  The 2016 resistance (lid) becomes the 2017 support (floor).  

By using price channels it’s incredibly easy to see the horizontal lines where resistance used to be.  This in turn makes it incredibly easy to look at the pullback low after the break and realize it’s holding where price used to stall out at.  

This is one of the primary benefits of using price channels for pullbacks.  They help show where price has come from in a clear and concise way.  

Rule #5. With Price Channels, the shorter the length, the stronger the chance for fakeouts.

This is the only rule where we try and give less wiggle room.  There are going to be times where a 5 length price channel works great, but the shorter the input length, the more chance of false signals.  

Typically, the standard price channel is 20 periods long.  This means price takes the last 20 highs excluding the current high and paints the highest high.  It takes the last 20 lows excluding the current one and paints the lowest low.

As a result, you get a 20 range price channel.  You can tweak the numbers and get more or less signals.  We recommend going up not down in length of the price channel, but there is a reason that 20 is standard.  It’s close to a full trading month, and it encompasses the majority of price action.


Putting It All Together

Let’s remember one thing.  No indicator is 100%, no matter how good the article makes it out to be.  If you are simply looking to trade breakouts better, trade pullbacks stronger, or looking for something to help filter your setups a little easier, this could be it.  As all other indicators are simply built off price action, why not trade an indicator that is price action itself.

That being said, however, nothing is fool proof.  Using this in conjunction with something like the cloud creates a pretty strong breakout strategy that can be done in under 15 minutes a day if you know how to scan.

That being said, it’s going to lose.  Everything is.  The key is picking a strategy that works for you, putting in the hours testing it and proving it out, and then starting small and building your trading plan the right way.  Because there’s always another SQ just around the corner, you just have to have the skills to get it.  If you need help building a trading plan, click here.

If you know someone else who would benefit from this teaching, pass us along.  

If you’d like to learn more about trading, our blog is always open.  Good Luck, and as always, trade your own plan.

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