Use This Technique to “Channel” Your Profits

We’ve talked before about the importance of Support and Resistance when looking at a stock chart. Back in October, I called it a trader’s “Swiss Army knife” and one of my go-to technical indicators. And we touched on it briefly again last week when I told you about Japanese candlestick charts.

Needless to say, Support and Resistance come up a lot when during the normal course of trading. They are incredibly important indicators of where a stock price might (or might not) be headed.

Today, we’re going to take a look at another way you can use Support and Resistance to identify potentially profitable options trades.

Let’s get to it…

Channel Your Profits

If a stock trades consistently between two parallel trend lines – Support and Resistance – over a period of time, this is called “Channeling.” When a stock trades in a channel consistently, a trader can benefit by recognizing a stock’s behavior in the channel. As long as the stock continues this pattern, traders can milk this technical pattern for all it’s worth.

In my trading, I consider a channel to have formed on a stock (or ETF, or whatever underlying you’re looking to trade) when it has traded off Support and Resistance at least two times. A more conservative trader may want three or more touches of support and resistance before ascertaining the channel is in place. Whatever number you’re comfortable with, just keep in mind that the more times the stock price has touched Support and Resistance, the more established the channel.

When traders or investors hear the term channeling, they probably visualize a stock that is trending sideways, creating a horizontal Support and Resistance line.

This is known as a Horizontal Channel, and while it’s a common type of channel, it isn’t the only one. Stocks trading in a channel are not necessarily range-bound – stocks can also trade in Ascending and Descending Channels as well (we’ll talk more about those later this week).

With that in mind, let’s take a look at an example of a Horizontal Channel.

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The parallel, horizontal green dotted lines are the extremes of a channel on Lennar Corp. (NYSE:LEN). The solid blue lines are a bit tighter of a channel where Support is shown around $47.50 and Resistance is shown at about $52.

It is rare to see a channel that trades exactly to the same support and resistance levels, so this is where technical analysis can be more art than science.

The channel determines the price range of trading for the underlying. In the above example with LEN, support can be determined to be $47.50 and resistance can be determined to be $52, giving the price range for LEN at $4.50.

I’d be wary of trading options on a stock with a range less than 2 points if the stock is $20 or more as the options may not have that great a chance to double.

Keep in mind the range of the channel compared to its stock price, though, as a $0.70 roll range on the channel for a $5 stock is a 14% potential ROI, (Return on Investment) on the stock alone. And if it can do this on a monthly or six-week basis, that could present a fantastic opportunity.

How to Trade the Channel

There are a variety of ways a trader can take advantage of a trade setup using a stock that trades in a channel.

Off Support: You can buy the stock, take a bullish or long call option, or bullish spread trade on Support with the expectation of closing the trade for profit once it trades up to Resistance.

From Resistance: You can reverse that and sell short the stock, take a bearish or long put option, or a bearish spread trade on Resistance with the anticipation of closing the trade for profit when it trades down to Support.

Take a look at the above chart on LEN and see if you can determine if it is currently on Support (meaning the price of the stock is currently in the low or lowest part of its range where it looks like prices will get supported from going any lower) or Resistance (meaning the stock is trading in the high or highest point of its range and it looks like it might resist going any higher).

If you said the stock is at Resistance, you’re absolutely right. This would make my anticipated short term future price move on LEN be to the downside, meaning you’d look for the stock to make a bearish move.

Managing Your Trades

The great thing about channels is they provide you with a reasonable price target and stop loss point for managing the risk in the trade.

As you can see in the LEN chart below, if you were to make a bearish play of Resistance, you’d likely want to set your stop loss if the stock closes above Resistance – that could be a signal that that the stock is breaking out of the channel you identified. Likewise, Support should be your target price

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You can place orders with your broker for you to exit the trade if the stock closes above the resistance price, or if it hits your price target at support.

Now, there are times when a stock will show a “false breakout,” closing above Resistance for one day before falling back into the range. You may want to consider setting your stop slightly higher, or waiting to see if the stock closes above resistance for two or more consecutive days before making your move.

Here’s your trading lesson summary:

Channels are a terrific way to visualize Support and Resistance and plot your next move.

  1. A Channel is created when a stock trades consistently between Support and Resistance levels.
  2. Traders can gain an advantage with a stock that trades in a channel because the stock’s behavior is more predictable.
  3. Remember: you’ll want to make a bullish move with a stock coming off Support, and a bearish move with a stock coming off Resistance.

On Thursday, I’ll be back with you to tell you a bit more about channels, including how to find them, how to assess their strength, and more on how to trade them.

Until then…

Good Trading,

Tom Gentile

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