On Tuesday, we talked about “Channeling,” and I told you how you can use a stock’s Support and Resistance levels to identify channels and better predict how a stock’s price will behave.
To illustrate the point, I used a horizontal channel – that is, a stock that’s trending sideways. It’s the easiest type of channel to identify and trade because you don’t have to account for a stock that’s trending up or down. So it was the perfect way to explain the basics.
But now it’s time to tackle something a bit more advanced.
We’re going to dig a bit deeper into channels today – there’s a lot that you need to know in order to wield this technique effectively.
So let’s get started…
The Strength of the Channel Tells You the Length of Your Trade
Let’s take a look at the “strength” of a channel and how that can impact your trading. When I say strength, I’m talking about a channel’s reliability – that is, how likely a channel is to continue.
So how do you know how reliable a channel will be?
It depends on how many times a stock’s price has touched and then bounced off its support and resistance levels. Here are some good rules to keep in mind:
- One to Two Times: If the stock price has touched and bounced from support and resistance at least two times, the stock is trading in a channel. However, keep in mind this is a relatively unreliable channel. More aggressive traders might still want to trade this channel, while more conservative trades may want to wait for more confirmation of the trend.
- Three to Four Times: This is a much more reliable channel, and most traders deem 3-4 touches of support/resistance enough confirmation to begin trading.
- Five to Six Times: This is considered a strong channel and is deemed reliable. Even more conservative traders will want to begin trading.
- Greater than Six Times: This is an extremely reliable channel.
Note you will miss out on the trades you don’t take depending on how reliable you require the channel to be.
The strength of a channel will help you determine the length of your trade.
The best way to do that is to look for a mirrored move. If the price move between support and resistance take 30 days on average, you should anticipate that it will continue to play out in that fashion.
You’ll need 30 days on average for the price move that you’re looking for, which means you can buy options with expiration dates beyond that 30-day range. That way, when the price makes its expected move, you’re still in your (hopefully very profitable) trade.
Let’s revisit Lennar Corp.‘s (NYSE:LEN) horizontal channel. Here’s the chart I showed you on Tuesday:
Last time, we decided that because the stock was sitting at resistance, we’d look to make a bearish move on LEN. So how many days does it take on average to make its move from resistance to support?
According to the chart, it takes about two weeks to make the move from resistance to support.
Your next move would be to look for put options (because, remember, we’re making a bearish play because the stock price is at resistance) that expire beyond the two-week period. I would generally look for an expiration of at least 30 to 45 days out to take advantage of the anticipated two-week move.
If you’ve been with me for a while, you know that I prefer short-term In The Money options. While they have a faster Theta (time decay) component due to their short-term nature, the Delta and Gamma help the premium increase at a faster rate when the stock makes its expected price move (for more on that, click here).
How to Find Channels
Finding channels can prove difficult. But it’s not impossible if you have the right tools…
You can manually scroll through thousands of charts looking to eyeball these channels, or you can use software that will automatically scan the markets and provide you with charts where the underlying is trading in a channel.
Check with your brokerage or online trading platform. Many have sophisticated charting tools that you can use.
My proprietary tools do this, and that’s how I found LEN. Take a look:
It gets a bit trickier to assess the target price for the move on ascending and descending channels, but it can be done.
Most charting software will allow you to draw trend lines on your charts, and you can extend them out so you can then see the anticipated price move. If you’re working manually, you can print out a chart and use your trusty ruler to extend out support and resistance lines to pinpoint where an ascending or descending channel is headed.
Here’s a quick look at an Ascending Channel, which is characterized by the price action being contained between upward-sloping (ascending) parallel lines. Just as with a horizontal channel, the price isn’t always perfectly contained within support and resistance levels.
And here’s what a Descending Channel looks like. As you can see, the price action is contained within downward sloping (descending) parallel lines.
The same trading rules are in place in that you are looking to trade bullish off support or bearish from resistance. You need to assess your target price and stop-loss point, and calculate the expected number of days it will take in order to determine which options expiration to use.
Channels are a great visual aid in helping traders determine ahead of time where support and resistance are. Knowing this helps determine entry points, price target expectations, and stop-loss points to manage your trades effectively.
Here’s your trading lesson summary:
|Now that you know what channels are and how to spot them, here’s a little bit more information on how to trade them.
- Assessing the strength of a channel is key to determining the length of your trade, and can help you make the most potentially profitable move. A channel’s strength is determined by how many times it has touched support/resistance.
- You can find channels manually by plotting moving averages on charts, or you can use proprietary software to automate the process. Your broker or trading platform may be able to provide this for you.
- Ascending and descending channels are more difficult to identify than horizontal channels.