The Price Channel Indicator: A Starter Guide
What is a price channel? No, it’s not a TV network starring Jim Cramer; it’s a technical analysis tool used to identify buy and sell points on an asset’s price chart. By using price channels, investors can note the direction of a trend but cannot locate specific price points where entries and exits give higher probabilities of success. Price channels aren’t crystal balls into future asset values, So investors must know the strengths and limitations of this tool before using it to trade.
What Is a Price Channel?
The term price channel originated to show how price data can follow a route similar to a canal or water channel. A price channel can be broad or narrow, in an uptrend or downtrend or flat across long periods. The idea is the same as the body of water from which it adopts its name — the asset price path forms a channel in the middle of a stock chart while the highs and lows of the price channel act as the coastlines. The channel shows the range of an asset’s price movement within the current trend.
How Does a Price Channel Work?
The price channel indicator showcases the upper and lower bound of the range during a market trend. The tool uses the highest highs and lowest lows to form the channel, with the upper and lower lines representing support and resistance areas.
When the asset’s price reaches the upper level of the price channel, it hits an area of known resistance and signals that current price gains may be nearing the end. The opposite is true when the price hits the channel's lower bound — it could signal that a support level has formed, and buyers will rush in when that level is reached.
Support and resistance are common technical trading tools used to identify entry and exit points in a particular asset. By using a price channel, you’ll be able to see where support and resistance levels have been recently triggered.
How to Read a Price Channel Chart
A price channel can form in uptrends, downtrends or horizontal trading ranges. Also known as Donchian Channels (after founder Richard Donchian), price channels include three lines on a chart.
The top line on the chart is the overbought level, where resistance has formed, and the stock may pull back. The bottom line is the oversold level, where buyers have recently come to support the stock. Finally, the middle line is the average of these two figures, described in more detail below.
What Is the Price Channel Formula?
Richard Donchian recommended 20-session timeframes on daily stock charts when using price channels. With these specifics, the formula reads like this:
The upper channel line is equal to the 20-day high.
The lower channel line is equal to the 20-day low.
The middle line is found by adding the 20-day highs and lows together and dividing by 2.
Three parallel lines will form following these rolling 20-day periods, creating a guideline for support and resistance levels within the current trend. Price channels can be bearish or bullish depending on the direction of the price movement.
Price Channel Indicator in Trading
Traders can use the price channel indicator in multiple ways. Short-term investors like day and swing traders can use price channels to quickly identify areas of support and resistance in trending markets. As long as the prevailing trend is strong, traders can enter positions at the lower channel line and exit if the stock price approaches the upper channel line.
Another way to use the price channel indicator is by looking for breakouts. If an asset’s price breaks through the lower or upper price channel, it could indicate that the current trend has ended and a new one is about to begin. However, false positives will happen, so use other indicators alongside the price channel for confirmation.
Advantages of a Price Channel
Can be easy to read: The price channel indicator offers precise support and resistance levels that can assist traders in making decisions.
Useful for different strategies: Traders can use the price channel to buy at support and sell at resistance or identify breakouts that may signal a new trend.
Bearish and bullish: Price channels can be used regardless of whether the asset’s current trend is upward or downward.
Limitations of a Price Channel
False positives: When an asset’s price bumps through resistance, it doesn’t always mean a new trend is forming. False positive signals are often called bear or bull traps, so you should use an array of indicators in your analysis.
Doesn’t include most recent data: The price channel only includes data from the previous periods and doesn’t incorporate the price from the current period (whether 5 mins, a day or a week).
Backward-looking indicator: The price channel shows a wide range of data but is not forward-looking. Price channels can’t predict when prices will return to resistance or gauge the current trend's strength.
Price Channels Are Useful, But Should Be Used with Other Indicators to Reduce False Positives
A price channel creates a range of recent highs and lows, allowing traders to identify support and resistance levels and receive signals should a trend breakout occur. While useful in asset price gyrations, the price channel is far from a perfect indicator. False breakouts are triggered frequently, and returns to support or resistance levels don’t follow a tidy timeline. Avoid using a single indicator as your only data point; find several that work together.
Frequently Asked Questions
Here are a few commonly asked questions about price channels and technical trading.
Why is a price channel important?
The price channel is a useful indicator because it can provide easy support and resistance reference points and can be used for breakout and range-bound trading.
What is a bullish price channel?
A bullish price channel has an ascending set of lines, indicating that the overall trend direction is upward.
What is a bearish price channel?
A bearish price channel is the opposite of a bullish one, with a descending set of lower highs and lower lows.
Disclosures:
All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful. This presentation discusses technical analysis, other approaches, including fundamental analysis, may offer very different views. The examples provided are for illustrative purposes only and are not intended to be reflective of the results you can expect to achieve. Specific security charts used are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.