How to Weigh the Pros and Cons of Trading Chart Straight-Line Channels - dummies

How to Weigh the Pros and Cons of Trading Chart Straight-Line Channels

On a trading chart, a straight-line channel is a pair of trendlines encasing a price series. It consists of one line drawn along the top of a price series and another line, parallel to the first, along the bottom of the price series. A channel can tell you a lot about price trends, but also has its drawbacks.

Considering the benefits of straight-line channels

When you use straight lines to represent a range, you get a chart that’s easy to read. Your eye fills in the blanks. The benefits include

  • Straight-line channels imply absolute limits that give you comfort and the sense that you know where you stand.

  • When a new price touches the channel top or bottom, but then retreats, you believe that the channel limits are correctly drawn and valid — and will likely work next time, too. The more often a price touches a support or resistance line but doesn’t cross it, the more reliable you can consider the line to be.

  • If a channel line is broken, you feel certain that something significant has happened to the perception of the security by its market participants. Violation of the channel alerts you to changing conditions and the need to consider making a trading decision.

A sense of certainty can be illusory and therefore dangerous. Like all technical indicators, channels only indicate; they don’t dictate.

Delving into the drawbacks of straight-line channels

If your price series is orderly and doesn’t vary much day to day from the average, the straight-line channel is fairly narrow. But if your chart contains a disorderly price move where prices jump around all over the place, your channel lines have to be so far apart that you can’t judge what is usual or normal.

To some extent, a channel is valid because many others can see the same thing. One of the reasons that a technical analysis method works is because it creates a self-fulfilling prophecy. When everyone can see the same lines, a consensus builds about what constitutes breaking the lines. When you draw a channel so wide or so narrow that only you can see it, you can’t expect other traders to respond to it. To forecast a price range is really to forecast the probable collective behavior of the people who trade the security.