Working With Trend Channels
Trend Channels can be very helpful in determining your entry or exit price for a stock trade. While regular trend lines show you the direction that the stock is moving, trend channels can show you where the stock is trading right now in comparison to the overall trend.
The premise behind the drawing of trend channels is all about finding the most visually appropriate channel. Lines that touch on the the extremes of the price action are less appropriate than building a trend line or trend channel that has the most touches on the price action.
Bullish Channel
On a bullish channel, the lower line is the trend line of the stock and is drawn by connecting low points of the stock price movements. The upper trend channel line is derived by drawing a line of best fit through the most recent peaks. The result is a "channel" that the stock has been trading in, sloped upwards. The drawing of these roughly parallel lines captures most of the price action in the channel.
Bearish Channel
On a bearish channel, the upper line is the trend line of the stock and is is derived by drawing a line of best fit through the most recent peaks while the lower line is constructed by drawing a line of best fit connecting the low points of the stock price movements. The result is a "channel" that the stock has been trading in, sloped downwards. The drawing of these roughly parallel lines captures most of the price action in the channel.
Example
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The chart above is of Woodside Petroleum (WPL) from August 2006 to mid-February 2007. The downward trend channel is clearly indicated above. The yellow areas are the support levels while the aqua areas are the resistance levels.
How To Trade this Pattern.
Realistically, you would not trade this pattern until the support/resistance lines of the channel have have been tested at least three times. It is better to see that the share price is actually confirming the pattern. In the above example, WPL hit the support and resistance lines three times each, thereby confirming the trend channel.
In this example, the share price is heading up to a resistance point. The trader would either wait for the price to break through the line and go 'long' or see if the line remains intact and then go 'short'.
