Ascending and Descending Channels

Trading on signals given by channels on the charts does not differ much from trading on the recommendations of technical traders, and it is similar to the principles of trade on ascending and descending trend- lines. A trading cycle usually starts from the lower border of the as- cending channel, by opening a long position and by opening a short position from the upper border of the descending channel. Stops need to be placed behind a channel border, and in case the stops are acti- vated, a position in an opposite direction (stop and reverse) could be opened.

A target for the channel trading is an area on the opposite side of the channel, where the initial position is liquidated and opens a new position in the opposite direction. Stops need to be placed outside the nearest bor- der of the channel; but if they are activated, you must reverse your posi- tion only if there are additional confirmations and signals about possible continuation of the market move in the selected direction. The profit will then be realized again on the opposite side of a channel, then the cycle re- peats again up to the moment when stops will be activated and the posi- tion will turn in the opposite direction.

Penetration of the upper border of the ascending channel or the lower border of the descending channel is not a valid signal to enter the market in the direction of a break. Only penetration of the lower border of the as- cending channel or the upper border of the descending channel is a suffi- cient signal for opening a position in the opposite direction from a channel. See Figure 9.8a and b.

Channel width

Minimum objective target

a

Stop and reverse

Sell

Buy

Stop and reverse

b

FIGURE 9.7 Channels are some of my favorite patterns. They always are obvi- ous on the charts and provide opportunities to trade in both directions, with mea- sured objective targets and tight stops.

Sell only

a

Buy only

b

FIGURE 9.8 I never start my trading by entering the market on the break of the upper border of an ascending channel and the lower border of a descending one, if there are no other additional signals received at the moment.

Horizontal Channel

Ideal (or almost ideal) horizontal channels are very rare on long-term charts, but they can be seen on the intraday charts. They are best seen on five-minutes to one-hour charts, or even on a four-hours chart. Because such a channel is formed by two horizontal lines, drawing through at least three points each (according to market laws mentioned earlier), both lines most likely will be broken in the near future.

My experience shows that:

• In the overwhelming majority of cases, the first break of a channel is false.

• After the break, there is a minor move in the same direction, then the market comes back inside the channel.

• After returning into a channel, the market crosses it and penetrates an opposite border.

• After the second break, there is a significant follow-through, which usually exceeds the width of the channel.

Some of my templates are based on signals given by a horizontal chan- nel formation. They will be discussed in Part IV, devoted to intraday trades. The choice of a trade tactic in the formed horizontal channel depends mainly on individual preferences of each trader rather than on the market condition, which basically repeats the same scenario just described, with few varia- tions. Any essential deviations are very rare, but they are possible. When I speak about trader’s individual preferences, I have in mind the trader’s desire to accept additional risk for an opportunity to gain greater profit. That de- pends on the degree of his conservatism, time invested in market supervi- sion, individual experience, and speed of reaction to a specific situation.

I use trade signals given by various technical formations a bit differently from the usual manner accepted in classical technical analysis.

Head and Shoulders (H&S)

H&S is the most recognized reversal technical formation and is very popular among beginners. Many novice traders can see H&S even if there is not even a trace of it on a chart. Seeing H&S where it does not exist occurs not only because of someone’s bright imagination but also because of insufficient knowledge of the basics of technical analysis. The alteration of waves in the market occurs constantly, and practically any sequence of contradictory

movements can erroneously be interpreted as H&S. This mistake often hap- pens when a trader has an open position and is searching for additional con- firmations of his point of view. Wishful thinking can play a malicious joke on a trader, and this actually happens rather frequently.

Therefore, before you apply technical signals related, for example, to H&S, learn to identify the formation first. In all textbooks of technical analysis, there are remarkable pictures showing how this formation should look. Therefore, I recommend that all readers refresh their memo- ries about the shape of H&S, and do not digress from the standard de- scription of the formation. When you have any doubts about unequivocal identification of a formation at the practical trade, it is better not to con- sider the formation as such. The formation can pretend to be real, if at least nine or ten traders are able to identify it. See Figure 9.9.

However, all obvious formations have one basic and obvious defect that the overwhelming majority of traders can see. Because you cannot expect to take a lot of money from the minority of the market participants (in this case, those who are not capable of identifying the formation for some reason), then complications are most likely to arise. This paradoxi- cal defect requires a solution.

FIGURE 9.9 To illustrate different thoughts and ideas, I’m using the same pic- ture of the inverted H&S formation over and over again, because this one has a per- fect textbook-like look that is unusual in the real market. Ten out of ten traders would recognize it.

On the one hand, technical analysis recommends that a trader open a new position in the direction of the market’s movement at the break of a neckline. On the other hand, under market laws, the crowd that thinks alike always should lose. The conclusion is: the probability of the correct (i.e., textbook) scenario of the H&S formation should not exceed 50 per- cent; for this reason, a trader has no statistical advantage, no matter how he acts in a similar situation.

The exit from an inconvenient situation is rather simple. First, because the neckline is a critical line, it is possible to apply a money management system such as the one already described in the example of trendlines, and use stops with reverse to achieve a desirable result. Then, you have to wait until the market leaves a critical zone going in one or the other direction. Secondly (and I frequently apply this method), you can play in advance of the situation and open a new position before such a formation is fully de- veloped. In the case of H&S, I prefer to take a new position at the point I expect to see a potential second shoulder top. The point of a potential sec- ond shoulder top is determined by drawing a line parallel to the neckline through the top of the first shoulder, which is already formed.

In the case of inverted H&S, such an entry point will be a possible low of the second shoulder. Stops have to be placed according to intraday sup- ports and resistances, but they can also be placed on some fixed distance from the opening position determined according to scale and size of this particular formation. Such an approach requires some practical experi- ence, but it is easy to learn. All you need to do in such case is pay atten- tion to the situation and keep it under control at all times.

Double Top (Bottom)

In this formation, my recommendations on a trade is the same as in the case of the H&S formation, but only in the part related to entry in the mar- ket on the break of a neckline. Don’t take a position without completion of the second top (bottom) because it is not always possible to define pre- cisely a point of entry into the market. Sometimes this formation deviates from a horizontal axis of coordinates and inclines on the side. My view is not different from the recommendations of classical technical analysis: protect yourself from a false break by placing relatively tight stops and re- versing the position if stops are triggered.

Date: 2015-12-17; view: 917