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Channeling Into Forex Profits By Mohammed Isah
Forex pairs are usually considered to move in defined trends. Here’s a trend-trading technique that can be applied to trading currency pairs or crosses. For both professionals and novices to master the game of trading, they have to learn and adopt certain strategies to help them achieve consistent profitability. To do this, specific price patterns need to be identified on the price charts and utilized as one of the tools to execute trades. My focus is on price channels. I will define what a price channel is, identify its importance both in technical analysis and trading, and establish how they are formed as well as how traders can use them to better enhance their trading decisions.
WHAT IS A PRICE CHANNEL?
A price channel is a chart pattern bound by upper and lower trendlines. This pattern can occur in a downtrend and uptrend. The two lines can also be called boundaries, with the upper one acting as resistance and the lower one acting as support. Price channels can be bullish, bearish, or sideways and short, medium, or long term, depending on which time frame you are looking at. Now that you know the basic definition of a channel, let’s turn to its characteristics.
CHARACTERISTICS OF A CHANNEL
Channeling as a trading pattern in technical analysis can be used in different ways to enhance your trading and execution. It creates trading opportunities, meaning it gives you clues as to where the market is headed in short, medium, and long terms. Channels:
- Create trading opportunities. In a typical channel trading environment, whether in an uptrend or downtrend, a trader can take directional advantage of channels or take trades in the direction of the channel, as you will see. The advantage is that it allows you to build positions or enter trades in the direction of the channel, whether it is an uptrend or downtrend.
- Define trends. Channels have natural characteristics of defining the trend. For example, in an uptrend a channel confirms the underlying trend of a particular currency pair. This gives traders more confidence to trade in the direction of the trend.
- Act as price targets. In a bull channel, traders can build long positions in a currency pair and set the upper channel or channel top as their profit targets.
- Serve as entry triggers. In an established bull channel, the lower channel acts as a support level and could serve as entry triggers.
- Help traders define or map market psychology. In an uptrend, for example, most traders buy a particular currency pair, while in a downtrend, most traders are likely to sell a currency pair. These actions help define the psychology of the market and help traders get an idea of what most traders are thinking or what their market sentiments are.
CHANNEL FORMATION
Typically, a channel requires two trendlines — upper and lower — for it to form, whether they are bearish, bullish, or sideways channels. There must be a minimum of two points connecting the upper trendline and two points to connect the lower trendline. On the daily chart of the EUR/USD in Figure 1, you can see an example of an uptrend. The first point of the lower channel line will start from the point labeled A. The next point will be at the next higher low (point B). The upper trendline will begin at point C and connect to the next higher high at point D.
FIGURE 1: BULLISH CHANNEL. For a channel to form, there must be a minimum of two points connecting the upper trendline and two points to connect the lower trendline. The first point of the lower channel line will start from the point labeled A. The next point will be at the next higher low (point B). The upper trendline will begin at point C and connect to the next higher high at point D.
In a downtrend like that displayed in the daily chart of the USD/CHF in Figure 2, the upper channel line is drawn starting from point A and connecting to the next lower high at point B. The lower trendline will connect point C to the next lower low at point D.
FIGURE 2: BEARISH CHANNEL. The upper channel line is drawn starting from point A and connecting to the next lower high at point B. The lower trendline will connect point C to the next lower low at point D.
TRADING CHANNELS
It should be obvious by now that the best market conditions to use or trade channels will be in uptrends or downtrends. Channels do not do well in a sideways trading range, even though it could still be considered a flat channel. It is easier to trade and make profits when you trade in the direction of the trend. Because of this, it makes sense to implement channels into charts of currency pairs, since they tend to move in prominent trends for the most part. However, it’s still a good idea to rely on other indicators in addition to trading based on channels. Other tools can be used to filter or confirm a trade entry or exit with a channel trading strategy.
In order to trade channels, you have to ask yourself what, as a currency trader, are the advantages that they hold. Here are some:
- Channels help you define entry and exit points or levels. This will be explained in more detail later.
- Channels also help identify where and how to place your stop-losses.
- Channels make you aware of when price may be moving in a direction opposite to what you had anticipated.
- Channels also give you an idea of when a trend changes.
Now, let’s look at how a simple channel trading system works. In this example, I will use the bullish channel that can also be applied in converse.
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In this example, I have used the relative strength index (RSI) with the channel line support or bottom to identify an entry point. As I mentioned earlier, it is a good idea to use a confirming indicator to help make better trading decisions. All the trades are placed in the direction of the bullish channel going up. In Figure 3 you see an example of how you can apply channels to the daily chart of the euro/US dollar (EUR/USD) currency pair. Note that in the real world, it may not be easy to find a picture-perfect bullish or bearish channel, so you may have to make some adjustments.
FIGURE 3: TRADING CHANNELS. Here you see how you can apply channels to the daily chart of the EUR/USD currency pair. There is a price decline, which began at the 1.4035 level and hit the channel bottom/support (or slightly below it) at 1.3784. It turned higher after holding at its channel support. If you look at the RSI (red arrow), you will see that it turned bullish and pointed higher, confirming the trade entry.
For you to take a trade in a bullish channel, the currency pair must test or pull back to its channel bottom and hold. In addition, the RSI will serve as a confirming or filtering tool to help you with your entry. It must turn higher at the same time the price hits the channel bottom or support and holds.
Figure 3 shows a price decline that began at the 1.4035 level and hit the channel bottom/support (or slightly below it) at 1.3784. It turned higher after holding at its channel support. If you look at the RSI (red arrow), you will note that it turned bullish and pointed higher, confirming the trade entry. Further, you can filter the trade by using the 60-minute or even the 30-minute chart by taking note of the two entry conditions. The second trade entry occurred after the EUR/USD pulled back and again hit its channel bottom at 1.3868. You can, of course, hold on to positions you already have instead of adding more.
EXIT POINT
Now that we know where to enter a trade, our next step is to know where to exit. It’s only natural to think of the top of the bullish channel as a resistance level, which would be the ideal place to exit your positions. Of course, there are times when that may not happen. So although you can expect to close your position when price hits the channel top, some channel trading exit strategies are dependent on styles of trading (daytrading or swing trading) and how much you are risking per trade.
WHERE TO PLACE YOUR STOP-LOSS
The best ways you can preserve your capital as a trader is to use stops in every position you open. It is a must if you want to be a successful trader. If you are an intraday trader, your stops must be tight, but if you are a swing trader, you can afford to have looser stops. A position trader will have even looser stops than the day- or swing trader. The example in Figure 3 is a swing trading style that allows you to hold your positions for days or even weeks. The stop-loss will be 40 to 50 pips below the 1.3754 level.
IS THE TREND CHANGING?
The three easy ways to detect a change in trend are when price fails to exceed the previous high; if the channel bottom/support is violated; and when your stop is hit or taken out. Channels present simple opportunities for entries and exits as well stop-losses. Channels can be identified on the charts and traded in whatever time frame you want to trade.
Mohammed Isah is a technical strategist and head of research at FXTechstrategy. com, a technical research website. He has written extensively on the forex market and technical analysis. He writes daily, weekly, and long-term technical commentaries on currencies and commodities. He provides full coverage of the forex market with specific focus on G10 currencies as well as the commodities markets, with focus on five key commodities.
