Price Channel Pattern Strategy (Backtest And Example)
Last Updated on March 8, 2023
Most traders attach trendlines across one swing side of a trend to delineate its direction. But to appreciate the individual price swings within a trend, you may need to have a price channel to see the up-and-down swinging movement of the price as it trends upward, downward, or horizontally. Now, you may be wondering: what is a price channel pattern strategy?
The price channel pattern strategy refers to two parallel trendlines or bands positioned above (channel resistance) and below (channel support) the current price action, within which the price swings are usually contained.
Traditionally, the channel is delineated with trendlines, which are usually placed across the swing lows and swing highs, but they can be marked by indicator lines placed at certain standard deviations or ATRs from the average price. The price channel pattern can be used to trade individual price swings within the channel or the breakout from the channel.
In this post, we take a look at the price channel pattern strategy, and at the end of the article, we provide you with a backtest of a price channel strategy.
What is a price channel strategy?
The price channel pattern refers to two parallel trendlines or bands positioned above (channel resistance) and below (channel support) the current price action, within which the price swings are usually contained. Traditionally, the channel is delineated with trendlines, which are usually placed across the swing lows and swing highs, but they can be marked by indicator lines placed at certain standard deviations or ATRs from the average price.
In a price channel, the price action is contained between these two parallel trendlines or bands, as the price bounces between parallel resistance and support lines. The resistance and support lines can run horizontally, sloping downwards, or upwards. When the direction of a channel is upward, it is considered a bullish channel; when the direction of the channel is downward, it is called a bearish channel. A horizontal channel implies a range-bound market.
The channel helps show the higher highs and higher lows that make up a healthy uptrend or the lower lows and lower lows that constitute a healthy downtrend. In an uptrend, if the swing highs are stuttering and not getting to the upper band or trendline, the uptrend may be losing momentum. Similarly, if the swing lows are not getting to the lower band or trendline in a downtrend, the downtrend may be losing momentum.
The price channel pattern can be used to trade individual price swings within the channel or the breakout from the channel. However, the separation between the two trendlines must be wide enough to trade inside the price channel pattern. If this is the case, you can buy at the channel support level and sell at the channel resistance level.
One of the best things about the price channel pattern is that it doesn’t matter if you’re looking at a daily chart or if your are a long-term trader – this chart pattern works with any trading timeframe, so it’s up to you to decide what timeframe you want to analyze. Another exciting thing is that price channel patterns can be found in all markets, including stocks, forex, mutual funds, futures, exchange-traded funds (ETFs), and more.
What is the psychology behind the price channel pattern?
The forces of supply and demand create a price channel in the chart of any security. Supply forces push the price downward, while demand forces push the price upward. A certain equilibrium level is reached for the price to swing within a channel, even though it may have an overall trend direction. Supply forces are more at the upper end of the channel, and you find more demand at the lower end of the channel. We can also argue price channels happen because of mean reversion.
The overall dominating faction would determine the prevailing trend — whether the channel is slopped downward, upward, or sideways moving. When supply is generally dominating, the price channel trends downward. Likewise, the price channel trends upward when there’s more overall demand. If there’s an even balance of supply and demand, the price channel is horizontal, so the trend is sideways.
Typically, traders, especially mean-reversion traders, like markets that trade within a price channel because they are easier to trade. When the price is at the upper end of the channel, there is a high tendency that it would trade down back to the lower end or, at least, to the center. Similarly, when the price is at the lower end of the channel, it is likely to trade higher toward the upper end of the channel.
Another aspect of price channels is that the price can break out of the channel by rising above the upper trendline/band or below the lower trendline/band. If the price action breaks above the upper trendline, it is likely to trend upwards, and if it breaks the lower trendline, it could trigger a downtrend.
Understanding the psychology behind the price channel breakout can potentially save you many losing trades. Regardless of the underlying trend of the price channel, a breakout signifies a major shift in direction or momentum (if the breakout is in the direction of the channel) of the price action.
Here’s why: many traders trade inside the channel and place their stop loss above and below the channel’s boundaries. With many stops gathering above and below the price channel pattern, the stops will eventually be targeted by smart money, as they need the liquidity the stops provide to feel their own orders.
How do you use a price channel?
When spotted, the price channel pattern can be very useful to a trader who knows how to use it. Regardless of your trading style, you can use the price channel pattern to improve your analysis and trading results. Here are some of the ways you can use the price channel pattern in your trading:
Monitoring the health of a trend
If you are a trend follower, you can use the price channel to gauge the health of the trend. An up-trending market consists of higher swing highs and higher swing lows, and if these swings form a channel, the swing highs should be reaching or even crossing the upper band of the channel for the trend to remain healthy. If the swing highs are stuttering and not getting to the upper band or trendline, the uptrend may be losing momentum so, if you have a trend-following trade, you should watch it closely.
Likewise, a downtrend consists of lower swing lows and lower swing lows, and when in a downward channel, the swing lows should be reaching the lower band of the channel for the trend to remain healthy. If the swing lows are stuttering and not getting to the lower band or trendline, the downtrend may be losing momentum.
Trading individual price swings
If the height of a price channel pattern is large enough, the individual swings within the channel can be traded. It is a popular mean-reversion kind of trade. On the daily timeframe or H4 timeframe, that is a goldmine for swing traders, as long as the price channel lasts, because the entry level and the profit target are very easy to identify — buy at the lower band and take profit at the upper band or sell at the upper band and take profit at the lower band.
Many swing traders, especially price action swing traders, use reversal candlestick patterns to know when to enter a trade when the price is around the boundaries of the channel. Indicator lovers may use momentum oscillators like the RSI or stochastic, which show overbought/oversold signals, for their trade entry trigger.
Another way to use the price channel pattern is to trade breakouts. Price channels don’t last forever; the price would break out of the pattern after some time.
If the price breaks out in the direction of the channel, it signals an increase in the price momentum. That is, for an up-sloping channel, an upward breakout is a sign of a high momentum in the existing bullish trend. For a down-sloping channel, a downward breakout signals a high momentum in the existing bearish trend. This kind of breakout is more difficult to trade, even though momentum traders might take them.
An easier breakout to trade is one that signals a potential change in the direction of the trend. A breakout below the lower band of an up-sloping channel is a signal to go short. Likewise, a breakout above the upper band of a downward-sloping channel is a signal to go long. For a horizontal channel, the breakout in any direction is a signal to trade in that direction.
How do you create a price channel?
How you create a price channel depends on the tool you want to use. If you want to create an indicator-based channel, you can attach the relevant indicator to your price chart and set it to the period you want. For example, if you want a 20-day Donchian channel, you attach the Donchian channel to your daily timeframe chart and set the period to 20.
However, if you want to create a traditional trendline-based channel, you attach the trendlines to the corresponding price swing highs and lows. For an uptrend, you first attach a trendline across the swing lows — it should touch as many swing lows as possible. Next, you place another trendline across the swing highs, making sure it touches the most important swing highs while remaining parallel to the first trendline.
For a downtrend, you first attach a trendline across the swing highs, making sure it touches as many swing highs as possible. Next, you place another trendline across the swing lows, making sure it touches the most important swing lows while remaining parallel to the first trendline.
There are also tools in the trading platforms that can draw channels for you when attached to the chart. They come with two parallel lines, which you can then drag to the swing highs and lows you want to use for the price channel.
Types of channel patterns
There are different ways to classify price channel patterns. You can classify them based on the indicator or tool used to create the channel or based on the direction of the channel’s slope.
Based on the indicator/tool, these are the common types of price channels:
- Trendline channel: This can be created with two trendlines attached across the swing lows (support line) and swing highs (resistance line). It is the traditional form of the price channel. You can create it by attaching the trendlines yourself, making sure they stay parallel, or you can use a channel tool on the trading platform that automatically creates two parallel lines that you can fix where you want.
- Bollinger Bands channel: The Bollinger Bands is an indicator with three lines: a middle line with a 20-period moving average of the price and an upper and lower band two standard deviations away from the moving average. The upper and lower bands create a channel around the price action.
- Keltner Channel: This is like the Bollinger band, except that the upper and lower bands are two ATR (average true range) away from the moving average in the middle. The upper and lower bands create a channel around the price action, and a breakout of the channel can signal a trade.
- Donchian Channel: This is an indicator with three lines generated by the moving average. The upper band marks the highest price of an asset over N periods, while the lower band marks the lowest price of the asset over N periods.
Based on the direction of the slope, we can have the following price channels:
- Upward price channel: In this case, the slope of the channel is upward. It shows a general uptrend. A breakout below it could signal a shift to a downward trend. A breakout about it is a sign of higher momentum.
- Downward price channel: Here, the slope is downward and indicates a general uptrend. A breakout above the channel could signal a shift to an uptrend.
- Sideways or horizontal price channel: In this type, the price is moving sideways and swings up and down within a horizontal channel. This channel can be called a rectangle chart pattern or a range-bound market.
The chart below is a D1 chart of the EUR/USD currency pair. It shows that the price is in a downward channel. You can see numerous swing trading opportunities appear at the boundaries of the channel. Not the bearish engulfing candlestick and the almost-a-hammer candle (upward white arrow). Notice how the RSI gives overbought and oversold signals on each occasion.
Price channel strategy backtest
Let’s end the article with a backtest of a price channel strategy. We use Bollinger Bands – probably the most known price channel bands.
We make the following trading rules:
- We make a 10-day Bollinger Band 1.5 standard deviations away from the mean (lower band).
- We buy when the close crosses below the lower band.
- We sell when the close crosses above the 10-day moving average.
Let’s backtest this strategy on QQQ, the ETF that tracks Nasdaq-100. This is what the equity curve looks like:
The 258 trades returned 8.3% annually, a performance that equals buy and hold. The trading statistics and metrics are reasonably good: profit factor is 2, and the win rate is 73%.
This is a mean reversion strategy and works well on stocks. On other assets, it doesn’t work well at all. Just look at SLV, the ETF that tracks the silver price:
This is a perfect reminder that one indicator or strategy is unlikely to work on many asset classes! Many traders reject a strategy because it doesn’t work on all assets and thus forego potentially lucrative strategies.
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