Thursday, October 4, 2012

Channel Theory I - Defining channels

Channels are heavily overlapped regions of price action that drift up or down in a chart. If the region did not drift, it would simply be BW. Channels are important because unlike BW which can only be scalped for a few ticks or a couple of points, channels do trend and can be traded for enough points to justify the risks of entering a trade. The goal is to trade channels with a fixed size stop such that the potential profit is larger than the risk taken with a high probability of success.

Channels generally have the following characteristics:

Multi-bar overlap: It is common for a bar to be overlapped by many following bars. For example, on the day on the right, b7 was overlapped by every bar except b1 and b19 until it finally broke out of the channel.

Tails: You are likely to encounter bars with tails on both sides, regardless of color. These tails look like a trend is just about to break when watched mid-bar and then the bar will close with the opposing color, leading to poor mid-bar decisions. Never make mid-bar decisions, especially in a channel.

Alternating bar colors: True channels have alternating colored bars with some dojis thrown in. Channels without opposing colored bars are Trend Channels (TC) and are actually simply trends. You can trade with-trend on the close of any small bar in TC but in a true channel you are likely to be stopped out if you use a fixed size stop. True channels that form a leg are leg channels (LC). Sometimes  a channel is so wide that it looks like a sloping trading range. These are trading range channels (TRC).

Unpredictable behavior: Channels may reverse (b19), break out (b30), may turn into any other type price action and are generally hard to predict.

The primary goal of trading channels is to determine the following:

1. Origin: Detect PA turning into a channel and determine direction.
2. Reversal: Channel may reverse direction while remaining a channel.
3. Breakout: Channel breaks into a steep trend move. This is the most important.

While even simple detection of a channel is valuable because it enables you to avoid getting chopped up, detecting breakouts and sharp moves intra-channel allow you to maximize your profits if you wish to trade channels. In the coming days, we shall see how each of these may be achieved.


  1. Hi Cad, really appreciated your posts, and very happy to join as your follower.

    I have a question if you don't mind, one concept as Al talks it almost everyday, "Always-in-long/short (AIL/S), but I didn't see you mention it even once. What's your opinion about AIL/S? Do you think the AIL/S concept may give people some excuses to scale-in when the market moves against their entries?

    Since the Signal bars in Channels are normally imperfect, Can scale-in work in Channel days?


    1. I don't believe the market oscillates between AIS and AIL all the time. Sometimes, it enters chop or a small trading range where there is no such thing as AIS/AIL. For me, the market is in an uptrend, downtrend or in chop. I have a slightly different system called the nine transactions based on this observation.

      Scaling in is a poor habit and a terrible idea. If you were wrong the first time, what makes you certain that adding more contracts will make you right? If you find yourself repeatedly stopped out and the market then moves in your favor, you would do better by skipping the first entry and only taking the second entry. In general, if you find the need to scale in, it implies you are unable to read price action properly.

    2. Thank you very much for your response.

  2. Hi Cadaver
    I have a question

    1. Have you ever use Price Action Technique to trade Forex ?
    2. Is it profitable in long run ?
    3. How is it different from Emini ?
    4. Which setup work(or not work) in Forex ?

    I have tried about 1 year and found that
    - It extremely hard to find perfect setup.
    - It hit my stop a lot (price can trap many times).
    - Sometimes each broker have different bar shape so I am not sure that the setup can be trust or not

    Sorry for my English :)

    1. 1. I have traded currency futures such as 6E, but never forex. However, it works the exact same way as equities.
      2. Depends on your skill level just like any other market. It takes time and persistence to be profitable
      3. The volatility is different and market moves at different hours.
      4. In general the same setups work for all markets, whether they are equities, forex or commodities.

      One way to get better setups is to trade a slower chart with larger stops such as a 30m chart.

      Forex is basically not an exchange and you trade opposite to your broker. As such every broker ends up giving a slightly different chart. You need to determine your stop for each setup based on statistical data collection. That is to say, for a given setup, you should determine that if you allow a pullback of x, you will be able to make a profit 70%+ of the time. Only then, its worth using the setup. The determination of stops and targets is no easy matter and takes a lot of time.

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