Can Channels Help With Trend Reversals?

Rick Wright

Hello traders! In this week’s Lessons from the Pros Newsletter I’d like to go into a brief explanation of trading with the trend, and a common pattern to help you trade against the trend.

Free WorkshopFirst of all, by now you have all heard the phrase (or one like it) that “the trend is your friend.” This essentially means that you should be trading in the direction of the primary trend based on your trading style. By trading style I mean day trader, swing trader, long term trader, etc. Each trading style will have a suggested set of time frames for you to watch; the largest is to help you identify the trend, the intermediate is for you to identify supply and demand zones to join the trend; and the smallest time frame is for you to time your entry in the specific zone. So, looking at your longest time frame, how do you define the dominant trend?

The common definitions of uptrends and downtrends are as follows: an uptrend is a series of higher lows and higher highs, while a downtrend is a series of lower highs and lower lows. Simple enough, right? Very often a trader will use a moving average or two, or even a trendline to help them to determine their trend. When used properly, these tools can be extremely helpful.

In this EURUSD 60 minute chart, the blue arrows mark the lower highs and lower lows of a downtrend, while the pink arrows mark the higher lows and higher highs of an uptrend. The point marked “1” shows where an aggressive trader might have noticed a break of previous highs, indicating a potential uptrend. The point marked “2” is where a more conservative trader should have noticed the uptrend beginning, with both a higher low and a higher high having been formed. This technique has been covered in several of our newsletters before; the next portion of this newsletter will help you determine when a trend may be ready to reverse, and perhaps get you in very early at the start of a new trend!

Using your trendline tool, you will have to draw in either an uptrend or a downtrend line. As you may know, a trendline must have (at least) three touches to be proven a valid, tradable trendline. Yes, this is in both up and downtrends. In the following chart, the GBPUSD has been in a downtrend marked by the solid black line. I formed a new parallel line, marking a channel, with a dotted black line. In a downtrend, when price moves so quickly that it goes below the lower channel line, this very often signals an unsustainable move in that direction-very often reversing directions shortly after. Looking back, a demand zone from September 2013 caused the short term change in direction.

The rules are as follows: when price breaks to the downside from a downward sloping channel, aggressive traders may go long in a quality demand zone.

In the following uptrending USDJPY 60 minute chart, price quickly moved outside of the upper channel line, directly into a previous supply zone.

Again, the aggressive trader will look to short after a fast move like this in a quality supply zone.

Please keep in mind that this does not signal a reversal immediately! You must still look to sell in a quality supply zone and buy in a quality demand zone. Does it work every time? Of course not! Nothing does. As long as you adhere to your stop loss rules and manage your winning trades accordingly, this can help you get into trades much earlier-perhaps even at the very beginning of a new trend.

Until next time,

Rick Wright

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.