Markets do not move in random directions. There are three states, which the market always follows, be it any stock, currency, cryptocurrency, etc. the market is seen to move only in these three states.
The three states are, namely, Ranges, channels, and trends. Identifying a trend is a skill in its own. If one masters the skill of identifying the state of the market, he can definitely sustain himself in the Forex industry. Well, there are price action traders in this industry who do not consider any indicator or pattern. Instead, they trade by understanding only these three states. Also note that a price action trader does not read ranges and channels as a pattern, but brings in a story to that pattern.
Channels and Ranges are quite similar. However, channels are easier to trade than ranges. The reason for this will be discussed in the subsequent topics.
In the previous article, we have discussed market ranges. And in this article, we shall be addressing Channels.
What is a channel?
A channel is a state of the market where the price does not hold at support and resistance but pulls back deeper. This definition might seem quite complicated. In simple terms, a channel is basically a tilted range. Also, the concept for trading channels is very similar to trading ranges.
Below is a representation of a channel inclined to the upside. If you observe carefully, it looks just like a range, the only difference, it is tilted upwards.
Interpretation of a Channel
Let us try understanding what a channel actually means. Consider the below figure. The market first went up and held at the S&R. It pulled back a little and then broke the S&R to make a higher high. But, it failed to do so as it did not hold above the S&R line. In fact, it came below the S&R line. However, it managed to hold above the previous support. And, from there it again breached the S&R but was unable to make a higher high and came back below the S&R. However, it was able to hold above previous support yet again.
Now, what can we interpret from this information? In the context of buyers and sellers; we can say that the buyers are pretty strong as they are always holding above their previous support. In other words, the buyers are willing to buy at a higher price than before. However, we can also say that the buyers are not quite strong because they are not able to make a legit higher high and hold above the S&R. Well, so how do we conclude this? We can conclude by saying that, in a channel, the buyers are relatively stronger than the sellers.
Why is it preferable to trade Channels over ranges?
In a range, the market does not hold at the previous support. In fact, it comes down until the support region and then goes up. Also, the market does not even attempt to make a higher high. From this, we can come to the conclusion that the buyers in a range are not as strong as the buyers in a channel. Also, in a range, the buyers and sellers are equally strong.
Now, assume that we are willing to go long. For our buy to work flawlessly, we would want the sellers to be weaker than the buyers. This is the reason we prefer a channel over a range because in a channel the buyers are stronger than the sellers.
Does location matter?
Here we are going to discuss that concept which is not taught anywhere on the internet. Even if you’re a pro at identifying channels, if you do not have an understanding of the location where the channel is occurring, it is going to be very challenging to make consistent profits from it.
Consider the example below. If we look at the most recent data, the market is channelling towards the upside. According to our interpretation above, a channel inclined upwards indicates that the buyers are quite strong so we must look to do the buy. However, in this example, it is very risky to do the buy. Reason being, the market is in a massive downtrend, and the channel represents that the market is just pulling back to go down eventually. While, the public, on the other hand, is still looking at it as a buy.
Now, if we consider the next example, we can see that the market is coming from a predominant uptrend. Later, the market starts to move in a channel. From this channel, we can interpret that the sellers are not able to break the support and begin their pullback. In other words, the buyers are not letting the sellers take over the market. Therefore, in this channel, we can look to go long as the risk becomes minimal.
Analyzing a Channel
Below is the chart of USD/JPY on the 60mins timeframe. The market broke the orange S&R, indicating that we are now in a seller’s market. The market then starts to move in a channel inclined downwards. Now that we know what the big players are up to, we can safely go short whenever the price comes to the top of the channel.
If we talk about the public, they buy at the bottom of the channel and sell at the top. But, the fourth time when the price touches the bottom of the channel, the market does not go up from there; instead, it gaps down drastically and makes a lower low.
A complete trade example
Before analyzing the channel, we first determine the location where the channel is being formed. In the below example we can clearly see that the market is coming from a massive downtrend. So, as the market is bearish and the channel is facing downwards, our main focus must be to go short.
From the above chart, the market in the channel is going up in a few candles and coming down in a few candles. This becomes difficult to bring out a story from the channel. So, to analyze the channel in detail, we switch our timeframe to a lower timeframe.
So, below is the same chart on the lower timeframe. Assuming if we were analyzing the live market, when do you think we would realize that the market is channelling? After the price reaches point 5 we would say that the market is on a channel. Now, with this information, we read the pullback from point 5, so as to hit the sell at point 6. But, we can see that the buyers from point 5 to point 6 were very powerful, so we do not take short trade from point 6. Also, since the buyers were very strong, the move from point 6 to point 7 took way too long.
By considering the below figure, let us read the pullback from point 7. We can see that the market broke above the dotted orange S&R and held above it. The market then pulled back to the dotted S&R (first red arrow), but it could not make any higher high. Later, the sellers shot down hard to the dotted S&R. From the second arrow, the buyers were again unable to make any higher high, in fact, it made a low high. And finally, the third time, the buyers got even weaker and formed the spinning top candlestick as well. From this, we can conclude that the buyers have completely given up, and the sellers are set to take the market lower.
Channels are that state of the market which fall between ranges and trends. In a range, both buyers and sellers are powerful. In a trend, either the buyer or the seller is dominant. While, in a Channel, both the parties are quite strong, but one party is comparatively stronger.
Also, in the above examples, we saw that the same looking channels have two different meanings. Therefore, understanding the location where the channel establishes is a significant factor to consider as well.