When using channels as part of a technical trading strategy, it’s good to know how spot the first signs of a price channel breakout. This holds true if you are trading the range or the breakout itself.
Even with all the tools in technical analysis there is no sure way to tell how a price channel will develop, or when a breakout will occur. Nevertheless there are some clues that we can use to understand what is going on and so have a more profitable trading system.
There are certain flags that we can use to predict when a breakout may be building and the direction that breakout is likely to take. These can be used together with a fundamental perspective.
Which Price Channels are “Reliable”?
Not all channels are easy to trade. In practice most aren’t. So an essential part of a price channel trading system is deciding which to trade and which to ignore.
The easiest starting point is to draw all of the nearby support and resistance levels. With Metatrader this can be done with a price channel indicator. Alternatively you can draw them in by hand. The advantage of using an indicator is that it’s less open to subjective interpretation.
When analysing a chart for “suitable channels” to trade, you need at least two or three bounces to define the support and resistance lines. If the channel forms on support and resistance that is already established, that can add some extra confidence on the range holding out.
A lot of traders wait for nearly perfect patterns to form before getting involved. But text book patterns that look “obvious” are few and far between. They’re also not the easiest to trade.
Remember for every transaction in forex there has to be a counterparty taking the other side. Where the crowd is trading predominantly on one side and expecting a certain outcome, the market makers are usually taking opposite positions. This soon unravels, as dealers try to unwind their positions. So the market reaction is the opposite direction to that expected.
How to Read a Price Channel Breakout
The chart below shows a short bearish channel forming on an hourly chart (USDCHF H1).
The first thing to notice about this price channel is that it’s a section within a much bigger trend. The zoom view (small box on left) shows that on a bigger scale this section looks like a small continuation pattern of the bullish trend.
This gives us a clue that the bullish trend could resume at any time. The channel, on a bigger scale, is a consolidation area. So a breakout is probably going to be to the upside and not the downside.
On this chart there are three main support/resistance lines. These are shown in yellow. A forth support line is also forming underneath the channel.
Analysing the price action at a channel break
The breakout starts to form around the two shaded circles. We can make some assumptions about what’s going on by examining the price action in more detail.
At point (1) a bullish engulfing candlestick appears. On the next bar another bullish engulfing candle appears. In this candle the price falls down to the lower support line shown by the long lower shadow. But it rallies back up strongly after touching the support. See Figure 3.
The third candle falls back briefly but makes a higher low than the last. The market rallies back up. It then closes well above the channel’s upper resistance line.
The ideal timing for the buy orders to trigger would be around the second or third candle. More conservatively we could wait for a break-and-hold of the upper resistance line.
Setting stop losses
Breakouts are tactical trades so there’s no point in holding on to the position if the market is going the other way. So with a channel breakout the stop losses would be best placed just below the lowest support line of the price channel. If that lower support line fails then an upward breakout isn’t likely any time.