Does The Channel Breakout Trading Strategy Work? (Rules, Backtest, Performance, Python)

The channel breakout trading strategy is one of many ways to trade breakouts. Breakouts are a popular trading strategy. As the name suggests, this method involves identifying and capitalizing on significant price movements as an asset breaks free from its typical trading range, or in this case, a “channel.”

In this article, we examine the effectiveness of the channel breakout trading strategy, formulate trading rules, and backtest it to determine its trading performance. 

Let’s have a look at the trading strategy, but first, let’s briefly explain what a channel breakout trading strategy is:

What Is A Channel Breakout Strategy?

A channel breakout strategy might buy a breakout to the upside or sell a breakout to the downside. Inversely, it might also sell a breakout to the upside, and buy a breakout to the downside. It depends on the assets you are trading.

In a channel breakout strategy, you’re essentially watching how the price of something behaves within a certain range. The interesting part comes into play when the price decides to step out of this established range, either shooting up or dropping below the channel. Here is a chart showing an example of a price channel:

When the breakout happens, traders often jump into action. If the price soars above the usual range, it’s a signal to consider buying. On the flip side, if it’s diving below the usual low, that’s a cue to think about selling. At least, that’s the theory.

It’s a bit like catching a trend as it unfolds—going with the flow of the market. To play it smart, traders use safeguards, setting points to exit automatically if things don’t go as planned or to secure gains when they’re ahead. Or at least this is the typical belief.

The whole idea is to ride the momentum of the breakout because it often signifies a shift in market dynamics or the start of a new trend. Traders stay vigilant, monitoring the situation to ensure it’s not just a brief deviation. But does it work? Let’s backtest some trading rules.

Channel Breakout Trading Strategy – Trading Rules

Let’s backtest the most basic channel breakout trading strategy that exists. The trading rules are the following:

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Channel Breakout Trading Strategy – Backtest

We backtested the strategy in the SPY. The data is not adjusted for dividends. Here is the equity curve:

The returns don’t seem that great. The CAGR is 3.54%, while the buy-and-hold is 8%.

We chose to set the high and low 20 days backward, but we could have opted for 50 or 100 days. To prevent cherry-picking, we conduct a backtest of the same strategy while varying the backward period from 3 days to 200 days.

Below is the histogram displaying the compounded returns based on the chosen backward days (the orange line is the SPY buy and hold performance):

Whatever backward period we choose, the strategy doesn’t beat buy and hold.

Inverse Channel Breakout Strategy

Let’s inverse the strategy we just backtested. The rules now are the following:

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Instead of buying strength, we buy weakness. The strategy converts into a mean reversion strategy. But does it perform well? Here is the equity curve:

The CAGR is 4.29%, better than the original strategy. However, it’s still not as good as buy and hold.

Let’s run the histogram displaying the compounded returns based on the chosen backward days again:

We see that a short lookback period performs well. Can we improve the strategy?

A Profitable Channel Breakout Trading Strategy

The trading rules for the profitable channel breakout trading strategy look like this:

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Here is the equity curve:

The CAGR is 9.42% vs. buy and hold’s 8%. We only added one extra indicator and a different exit rule, and the performance increased dramatically. Moreover, the strategy is only invested 51% of the time.

Does The Channel Breakout Trading Strategy Work? – Conclusion

To sum up, we made an inverse channel breakout trading strategy with good trading performance. We showed you multiple variations, and lastly, backtested a profitable strategy. 

Channel Breakout Trading Strategy – Python Code