Trading channels is a well-known and often-used trading technique. Here we look at how you can construct your own channel spread trading strategy.

The technique is based on the observed tendency of many financial instruments to set a direction and then maintain it for a period of time. A change of such a paradigm is often well connected with planned and unplanned macroeconomic events.

A recent example would be the sovereign debt crisis in the EU, led by Greece. Once the information emerged, many instruments shifted and reversed some of their existing underlying trends.

A channel is defined when an instrument’s price is confined between two upper and lower parallel bands. The lower line is considered support and the upper line considered as resistance.

In order to claim a channel has formed we must have at least four touch points, two on the supporting band and two on the resistance band. The more points connected without material breakout, the stronger the channel will be considered.

As you may already guessed we have three types of channel:

• Ascending – When the price action exhibits a positive slope with rising tops and rising bottoms.
• Descending – When the price exhibits a negative slope with falling tops and falling bottoms.
• Sideways – When the price does not exhibit a particular slope. This is combined with a mix of rising and falling tops and bottoms. Sideways movement can also be broken down again into categories:
  • Diverging Sideways – This is best described as a combination of rising tops and falling bottoms, such that the price action diverges, yet the overall pivot line remains roughly the same.
  • Horizontal – When support and resistance bands are parallel with each other but with minimal or no visible slope.
  • Consolidation – A combination of falling tops and rising bottoms, such that the price action converges towards the pivot. Equilibrium may be achieved momentarily.

Plotting a channel

There are many ways of drawing a channel. The first, and most common, is drawing parallel lines, using the naked eye, which try to connect as many touch points as possible according to the principles outlined above.

A more scientific method would be to use linear regression to plot the pivot line and build the channel around it. There are three main methods of channel building that are based on linear regression:

• Standard Deviation Channel – Two lines can form a standard deviation channel if they are parallel to the linear regression trend line. These are usually set two standard deviations either side of the regression line.
• Standard Error Channel – The standard error can also be used, in place of the standard deviation. This is preferred by some investors. It is the standard deviation divided by the square root of the sample size.
• RAFF Channel – The distance between the channel lines and the regression line is the greatest distance that any one closing price is from the regression line.

Building your channel trading strategy

There are countless ‘off the shelf’ strategies for channel trading but we will look at the ingredients for building your own custom channel trading strategy.

From each section below you should pick the method that you find most suitable for your own trading style. Once you have determined which methods to use, you will have a comprehensive strategy that covers all the necessary aspects of channel trading.

It is highly recommended with any trading strategy, be it channel trading or otherwise, that you backtest your strategy using automated tools such as eSignal or NinjaTrader. This may demonstrate a potential flaw before you risk your own trading capital.

Entering the trade

As mentioned, there are several methods for entering into a trade: you can decide to either trade with the trend, against the trend or even trade both.

Trading with the trend is considered the safest method as it mostly enjoys a higher accuracy rate. In fact, even when a channel is broken, breakdowns do have a tendency to recover at least to the bottom of the channel, which can be an exit point either for breaking even or with a small profit.

Another option is to trade both ways: short on a breakout from the upper band and long on breakdowns from the bottom band.

The greatest benefit of trading both sides is that you may get lucky and hit a material reversal, i.e. you could be catching the top of an uptrend channel switching to a downtrend or vice versa. These are the rare occasions when out-of-scale profits can be made.

The third method would be trading only against the trend. Some traders see the sense in this but, personally, I don’t.

One thing to note is that with a spread betting or CFD trading account investors can gain quick access to a range of financial markets and you are able to trade in both directions, i.e. trade either long or short.

Exiting the trade

Many traders take the view that getting out of a trade is as important, if not even more important, than getting into it. When trading channel breakouts you have several important decision points.

The first one is channel recovery, when the price either falls or climbs back into the channel. You should pay careful attention to the patterns developing around the boundaries and decide if this is the time to close the trade.

The second important decision point would be the pivot line. Pay extra attention to this point especially when trading against the trend as counter-trend movement sometimes breaks around the pivot line.

The third and last decision point would be the opposite boundary. If you have reached this point you should be deep in profit so it’s probably the time to play it safe and secure the majority of your gains as realised profit.

Entry and exit style

The simplest way to enter and exit trades is to decide in advance how much you are willing to risk on a specific trade and work out the desired stake size. Yet there are also more sophisticated ways to trade:

• Scaling in – When using this method you would usually divide your overall investment into three batches. A third is to be placed when opening the trade. The second third would usually go in after the price has recovered back into the channel. And the final third would be added once the price has crossed the pivot line and the direction of the current movement is confirmed. When the price target has been reached the whole position will be closed. This method allows the trader to increase their stake only when price action is going their way and, by trailing the stops, the risk factor may remain the same despite increasing the overall stake.
• Scaling out – When using this method you would place your entire stake when opening the trade and reduce your exposure as price action moves your way, locking in more and more profit.

Both trading styles are very much valid and investors can alternate between them as they see fit. In my experience, scaling in works out better when trading against the trend and scaling out delivers better results when trading with the trend.

Capital management

One important trading rule that many investors follow is to refrain from risking more than 1-2% of trading capital on a single trade.

Aside from this, it is also advisable to build a well-diversified portfolio where some of the contracts act as a hedge on others. This is to reduce the risk of all your holdings running against you simultaneously as the result of an unforeseen event.

For example, let’s assume you decide to open various long positions on the US dollar against the Japanese yen and the British pound.

Both Britain and Japan are net importers of commodities and are therefore susceptible to changes in commodity prices. A natural hedge against these would be to take short positions on the Australian and Canadian dollars as these two countries are net exporters and will enjoy increased commodity prices.

This is especially necessary when trading the FX markets as positions can be very volatile. In addition, remember that the markets are well connected and you should always try to quantify your real net exposure. This can be done by summing the long and short trades you may have in multiple positions.

Hedging and net exposure example:

Net exposure:

Instrument	Exposure	Overall risk (pips)
USD	100,000	412
EUR	-150,000	250
GBP	-50,000	120
CHF	-50,000	125
AUD	100,000	83
CAD	50,000	60

 

You may observe that the positions which are placed to hedge any unfavourable movement have Stop Losses which are placed much tighter than the ‘main’ positions.

This is so that once the market moves in the ‘correct’ direction we will be looking to remove the hedge, allowing us to enjoy the most of the current swing in the market. It is always important to reevaluate your risk once some of the positions are closed.

Stop Loss and Take Profit

Stop Losses should basically be placed very near to the closest high for short trades and next to the closest low for long trades. In essence you need to pinpoint a price level where the view that a reversal is imminent is invalidated.

When a trade is going well there are two key points where investors should consider trailing stops. The first is once the market has regained the channel and completed a corrective movement. Many traders choose to trail the stop close to the peak, for short trades, or bottom, for longs, of the movement.

The second trail should come into effect once the price has pierced through the top of the channel. This is where you must carefully control your Stop Loss and Take Profit orders to optimise your exit from the trade.

Unlike Stop Losses, which are strongly advised in any position, Take Profit orders are something that many traders find they can do without.

Yet this doesn’t mean that targets should not be set. When the price is getting closer to the target area it becomes important to make judgment calls according to emerging patterns, momentum and overall market sentiment.

Please note that Stop Losses are not guaranteed and may be subject to slippage (positive or negative) and market gaps in volatile market conditions.

Good luck and happy trading.

Shai Heffetz

Published: 13 July 2010

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.