Friday, October 5, 2012

Channel Theory II - Origin

Once we have a definition of a channel, we can apply that to detect when price action displays signs of turning into a channel. In general, when the signal and entry bars are poor, i.e. overlapped and taily, I watch for channel formation.

Since in normal trends signal and entry bars are clearly not overlapped (b4,5 or b6,7 or b8,9), any heavy overlap of signal and entry bars should put you on guard. In particular if the entry bar and the next two bars overlap the signal bar, you have certainly entered a channel. Therefore on this day, at b20, you have already detected a channel.

Detecting channels is not complete until channel direction is also determined. This is trickier to do in real-time since what looks like a channel down simply completes a structural requirement of say three legs and then changes direction.

A channel direction is canonically determined when you can draw a channel trendline.  The earliest direction estimate comes from two LL and a LH or two HH and a HL. Therefore today you would confirm a downward channel at b24. Sometimes what looks like a channel can quickly turn into a triangle or expanding triangle and trap you if you enter too early.

Conflicting channel trendlines (shown above) are common during the nacent phase of the channel. This is a common cause of stop-outs and finding oneself on the wrong side of the market. While the trendline from the start of the move (b13) is usually the best trendline for big picture, channels often test the trendline from channel start (b19).

Never get trapped into thinking that a channel has reversed on the first attempt and trade the newly turned trendline (b33-41). These succeed rarely.

Once you are in a channel, you need to switch your trading to channel mode. Practices that are poor in normal trading such as fading bars become viable in channels and practices that are good in normal trading such as fixed stops and entering on signal bar breakouts lose their strength in a channel.

You could simply wait for price action to break out of channel mode and then look for an entry. When a pullback no longer overlaps the signal bar (b47) you can safely take with trend entries without fear of being stopped out (b59 s, b64s).