Price Channel Pattern Strategy – Backtest and Illustrative Example
Most traders attach trendlines across one swing side of a trend to delineate its direction. But to appreciate the individual price swings within a trend, you may need to have a price channel to see the up-and-down swinging movement of the price as it trends upward, downward, or horizontally. Now, you may be wondering: what is a price channel pattern strategy?
The price channel pattern strategy refers to two parallel trendlines or bands positioned above (channel resistance) and below (channel support) the current price action, within which the price swings are usually contained.
Traditionally, the channel is delineated with trendlines, which are usually placed across the swing lows and swing highs, but they can be marked by indicator lines placed at certain standard deviations or ATRs from the average price. The price channel pattern can be used to trade individual price swings within the channel or the breakout from the channel.
In this post, we take a look at the price channel pattern strategy, and at the end of the article, we provide you with a backtest of a price channel strategy.
What is a price channel strategy?
The price channel pattern refers to two parallel trendlines or bands positioned above (channel resistance) and below (channel support) the current price action, within which the price swings are usually contained. Traditionally, the channel is delineated with trendlines, which are usually placed across the swing lows and swing highs, but they can be marked by indicator lines placed at certain standard deviations or ATRs from the average price.
In a price channel, the price action is contained between these two parallel trendlines or bands, as the price bounces between parallel resistance and support lines. The resistance and support lines can run horizontally, sloping downwards, or upwards. When the direction of a channel is upward, it is considered a bullish channel; when the direction of the channel is downward, it is called a bearish channel. A horizontal channel implies a range-bound market.
The channel helps show the higher highs and higher lows that make up a healthy uptrend or the lower lows and lower lows that constitute a healthy downtrend. In an uptrend, if the swing highs are stuttering and not getting to the upper band or trendline, the uptrend may be losing momentum. Similarly, if the swing lows are not getting to the lower band or trendline in a downtrend, the downtrend may be losing momentum.
The price channel pattern can be used to trade individual price swings within the channel or the breakout from the channel. However, the separation between the two trendlines must be wide enough to trade inside the price channel pattern. If this is the case, you can buy at the channel support level and sell at the channel resistance level.
One of the best things about the price channel pattern is that it doesn’t matter if you’re looking at a daily chart or if your are a long-term trader – this chart pattern works with any trading timeframe, so it’s up to you to decide what timeframe you want to analyze. Another exciting thing is that price channel patterns can be found in all markets, including stocks, forex, mutual funds, futures, exchange-traded funds (ETFs), and more.
What is the psychology behind the price channel pattern?
The forces of supply and demand create a price channel in the chart of any security. Supply forces push the price downward, while demand forces push the price upward. A certain equilibrium level is reached for the price to swing within a channel, even though it may have an overall trend direction. Supply forces are more at the upper end of the channel, and you find more demand at the lower end of the channel. We can also argue price channels happen because of mean reversion.
The overall dominating faction would determine the prevailing trend — whether the channel is slopped downward, upward, or sideways moving. When supply is generally dominating, the price channel trends downward. Likewise, the price channel trends upward when there’s more overall demand. If there’s an even balance of supply and demand, the price channel is horizontal, so the trend is sideways.
Typically, traders, especially mean-reversion traders, like markets that trade within a price channel because they are easier to trade. When the price is at the upper end of the channel, there is a high tendency that it would trade down back to the lower end or, at least, to the center. Similarly, when the price is at the lower end of the channel, it is likely to trade higher toward the upper end of the channel.
Another aspect of price channels is that the price can break out of the channel by rising above the upper trendline/band or below the lower trendline/band. If the price action breaks above the upper trendline, it is likely to trend upwards, and if it breaks the lower trendline, it could trigger a downtrend.
Understanding the psychology behind the price channel breakout can potentially save you many losing trades. Regardless of the underlying trend of the price channel, a breakout signifies a major shift in direction or momentum (if the breakout is in the direction of the channel) of the price action.
Here’s why: many traders trade inside the channel and place their stop loss above and below the channel’s boundaries. With many stops gathering above and below the price channel pattern, the stops will eventually be targeted by smart money, as they need the liquidity the stops provide to feel their own orders.
How do you use a price channel?
When spotted, the price channel pattern can be very useful to a trader who knows how to use it. Regardless of your trading style, you can use the price channel pattern to improve your analysis and trading results. Here are some of the ways you can use the price channel pattern in your trading:
Monitoring the health of a trend
If you are a trend follower, you can use the price channel to gauge the health of the trend. An up-trending market consists of higher swing highs and higher swing lows, and if these swings form a channel, the swing highs should be reaching or even crossing the upper band of the channel for the trend to remain healthy. If the swing highs are stuttering and