Channels are essentially two parallel trendlines which contain price action within a bullish or bearish trend. However, channels have the additional benefits to the simple trendline. Firstly, they can provide a dynamic target as the channel progresses. Furthermore, how price action behaves within the channel can also provide clues as to whether underlying momentum within the trend is increasing or diminishing.
Similar to drawing a trendline, a trader would connect two rising troughs in an uptrend, or two lower peaks in a downtrend to begin drawing a channel. A second trendline then runs parallel to the initial trendline which is then projected into the future.
Within MT4 there are 4 dedicated channel tools:
- Equidistant Channel
- Standard Deviation Channel
- Linear Regression Channel
- Fibonacci Channel
Classical technical analysis generally favours the Equidistant Channel tool. This is no surprise given they were invented back when charts were drawn by hand and trendlines drawn with rulers. Simple by design and nature, two parallel trendlines are drawn at the same time and the user controls how wide the channel is and the trajectory the channel is rises or falls.
However, there are two ways to draw an equidistant channel within MT4
- Use the Equidistant Channel tool
- Use the standard trendline
Whilst either approach has the same goal in mind, there are slight differences in approach and visual output, so it is encouraged that the trader experiment with both methods to discover which is of greater use to their needs.
How to Draw Channels
Equidistant Channel Tool:
The trader must select two swings for the tool to draw a channel. By selecting the channel, four small squares will appear on the trendlines which allow the trader to adjust the channel accordingly.
On the initial trendline the user draws: The first and third square adjust the trajectory of the channel. The centre square will move the entire channel around the screen without adjusting the channel’s dimensions in any way.
Computer generated trendline: The single square on the parallel trendline allows the user to adjust the width of the channel.
By default, both trendlines forecast into the future with a ‘Ray’. For unknown reasons it also draws the parallel trendline into the past. Occasionally these rays can clutter up the chart, but the user can remove them as follows.
Select the drawn channel > Right mouse click > Channel Properties > Uncheck ‘Ray’ button
Drawing Parallel Trendlines for Channels
However, the channel performed this way is not always that useful. So another approach is to simply copy a trendline with the ‘Ray’ feature activated. This way the user still has complete control over the channel’s trajectory and width without one of the channel’s trendlines beings drawn into the past.
Draw a regular trendline > select trendline > Hit Ctrl and drag up from middle box of trendline > Position new trendline to create the channel
Trading Channels in Practice
The following examples have used a duplicated trendline to forecast the channel, although the equidistant trendline can also be used.
- At 16:00 on the 17th November, EUR/NZD produced a bearish 2-bar reversal on the H4 chart. As it suggested a lower high was in place, a trader could then project a bearish channel to use as a future profit objective.
- With the initial trendline in place, a parallel trendline could be connected to the prior swing low and projected into the future.
- On this occasion the market clearly respected the channel. After moving lower in line with the bearish trend, a 2nd lower low formed at the lower trendline of the channel and a reversal occurred.
- After retracing higher, a lower high formed but didn’t quite test the upper channel’s trendline. This shows a slight increase in bearish momentum, but ultimately the channel continued to contain price action so the trader can then refer to the lower trendline for the next target.
- Prices move lower within the bearish channel yet failed to hit the lower trendline. This sends a warning that bearish momentum is waning. A longer-term trader who wishes to ride out the larger fluctuations could use a break of the upper trendline to stop the trader out. Yet a bearish swing trader, who generally does not want to ride the larger fluctuations may want to tighten their stop to protect profits at this point.
- Price drifted higher yet the bullish move lacked momentum. Again, the upper trendline is yet to be tested which is a good sign for bears. A small bearish inside bar appeared on the next bar which may have been of interest for swing traders for a potential short trade.
- After printing a small bearish candle, bearish momentum took prices aggressively lower and beyond the lower trendline.
- Despite the strong sell-off and intraday break beneath the lower trendline, the candle closed back above it by the close of the bar. This could have provided a reason to exit for some traders, or at least tighten their stop. Those who had a take-profit located on or around the trendline would have been automatically closed out. Those who waited would have seen a bullish pinbar and bullish hammer close above the lower trendline to warn of a potential reversal higher.
- Prices retraced higher within the channel, potentially stopping out a trader who had trailed their stop aggressively lower.
Using the same example of EUR/NZD, a new channel could also have been projected as the trendlines accelerated lower. So after prices have retraced higher from the bullish pinbar and bullish hammer, prices were not approaching a potential inflection point around the upper trendline and 1.0650 resistance.
Tests of a Channel Can Create Two-Way Trading Plans
Each time a trendline is tested a trader should be on guard for a bullish and bearish opportunity. This is because the trendline will either hold and see momentum realign with the dominant trend, or prices will break out of the channel and create a counter-trend opportunity.
As we highlighted in our daily report on the 4th September 2020, USD/CAD was trading within an established bearish channel. A strong counter-trend rally had taken prices to test the upper trendline and prices were hovering near a pivotal area of resistance around 1.3120 – 1.3135. As employment data for US and Canada was released later that day there was a higher probability of volatility, and for a strong momentum move away from the trendline in either direction.
A trader could have therefore created a trade plan for either scenario and acted accordingly if price action triggered a potential trade idea after the news release. Incidentally, there was a strong bearish move after the employment reports were released, before prices eventually broke higher and invalidated the channel the following week.
Like trendlines, channels are great until they break. Yet how prices react within channels can also provide clues that prices may reverse and break outside of its channel. In this example we show how the characteristics of price action changed within the later stages of the channel to suggest the tide could be turning, before it actually did.
- AUD/NZD was trading within an established bearish channel throughout September 2020.
- The bearish moves failed to test the lower trendline on three occasions, suggesting the bearish move was slowly losing momentum.
- Prices rallied sharply and tested a prior swing high. This is not conductive of a strong bearish trend, although it didn’t quite confirm a trend reversal.
- Prices moved lower and printed a higher low (HL) to again suggest the dynamics within the channel had changed.
- Prices retested the upper trendline. Whilst they did not break higher, once again it sends strong warnings signals that the bearish channel is less reliable than it was.
- Prices fell and initially broke a prior swing low. Had bearish momentum continued then the trader could have assumed that the bearish trend remained respected. Yet the quick reversal higher sent another warning that the dynamic had changed within the channel and it may become invalidated shortly.
- A bullish breakout occurs to invalidate the bearish channel. Traders could revert to break of trendline strategy at this point.
- The classic equidistant channel is the most popular type of channel for traditional technical analysts.
- Equidistant channels allow a trader to formulate discretionary trading strategies.
- Channels can provide dynamic take profit and aid with stop loss management.
- A trader can formulate bullish and bearish trade plans when price action tests an upper or lower trendline.
- Price action can provide clues that the dynamics are changing within a channel, and therefor a change of trend may be occurring (before it actually does).