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Channels
Markets are manic-depressive beasts. They rise in powerful rallies, only
to collapse in breathtaking declines. A stock catches the public’s fancy,
shoots up 20 points one day, and then slides 24 points down the next.
What drives those moves? Fundamental values change slowly, but waves
of greed, fear, optimism, and despair drive prices up and down.

How can you tell when a market has reached an undervalued or overvalued
level, a zone for buying or selling? Market technicians can use
channels to find those levels. A channel, or an envelope, consists of two
lines, one above and one below a moving average. There are two main
types of channels: straight envelopes and standard deviation channels,
also known as Bollinger bands.
In Bollinger bands the spread between the upper and lower lines keeps
changing in response to volatility. When volatility rises, Bollinger bands
spread wide, but when markets become sleepy, those bands start squeezing
the moving average. This feature makes them useful for options traders
since volatility drives options prices. In a nutshell, when Bollinger bands
become narrow, volatility is low, and options should be bought. When they
swing far apart, volatility is high, and options should be sold or written.
Traders of stocks and futures are better off with straight channels or
envelopes. They keep a steady distance from a moving average, providing
steadier price targets. Draw both lines a certain percentage above or
below the EMA. If you use dual moving averages, draw channel lines parallel
to the longer one.
A moving average reflects the average consensus of value, but what is
the meaning of a channel? The upper channel line reflects the power of
bulls to push prices above the average consensus of value. It marks the
normal limit of market optimism. The lower channel line reflects the power
of bears to push prices below the average consensus of value. It marks the
normal limit of market pessimism. A well-drawn channel helps diagnose
mania and depression. Most software programs draw channels according
to this formula:
Upper channel line = EMA + EMA • Channel coefficient
Lower channel line = EMA − EMA • Channel coefficient
A well-drawn channel contains the bulk of prices, with only a few
extremes poking out. Adjust the coefficient until the channel contains
approximately 95 percent of all prices for the past several months. Mathematicians
call this the second standard deviation channel. Most software
packages make this adjustment very easy.
Find proper channel coefficients for any market by trial and error. Keep
adjusting them until the channel holds approximately 95% of all data, with
only the highest tops and the lowest bottoms sticking out. Drawing a channel
is like trying on a shirt. Choose the size in which the entire body fits comfortably,
with only the wrists and the neck poking out.
METHOD—TECHNICAL ANALYSIS 95
Different trading vehicles and timeframes require different channel
widths. Volatile markets require wider channels and higher coefficients.
The longer the timeframe, the wider the channel; weekly channels tend to
be twice as wide as dailies. Stocks tend to require wider channels than
futures. A good time to review and adjust channels in futures is when an
old contract nears expiration and you switch to the new front month.
A channel drawn in an uptrend tends to fit the peaks. Rallies in a bull
market are much stronger than declines, and bottoms seldom reach the
lower channel line. In a downtrend, a channel tends to track bottoms,
while the tops are too limp to rise to the upper channel line. It is unnecessary
to draw two separate channels, one for the tops and the other for
the bottoms; just follow the dominant crowd. In a flat market expect both
tops and bottoms to touch their channel lines.
When we are bullish, we want to buy value near the rising EMA and take
profits when the market becomes overvalued—at or above the upper channel
line. When bearish, we want to go short near the falling EMA and cover
when the market becomes undervalued—at or below the lower channel line.

If you buy near a rising moving average, take profits in the vicinity of
the upper channel line. If you sell short near a falling moving average,
cover in the vicinity of the lower channel line. Channels catch swings
above and below value but not major trends. Those swings can be very
rewarding. If you can catch a move from the EMA to the channel line in
bond futures, you’ll make about $2,000 in profit on a $2,000 margin. If
you can do this a few times a year, you’ll find yourself far ahead of many
professionals.
A beginner who sells his position near the upper channel line may
regret it several weeks later. In a bull market, what looks overvalued today
may look like a bargain the next month. Professionals do not let such feelings
bother them. They are trading, not investing. They know it’s easy to
be smart looking at old charts, but hard to make decisions at the right
edge. They have a system, and they follow it.
When prices blow out of a channel but then return to the moving average,
trade in the direction of the slope of that MA, with a profit target near
the channel line. Prices break out of channels only during the strongest
trends. After they pull back, they often retest the extremes of those break-
outs. A breakout from a channel gives us confidence to trade again in its
direction.
Prices occasionally take off on wild runaway trends. They break out of a
channel and stay out for a long time, without pulling back to their EMA.
When you recognize such a powerful move, you have a choice: stand aside
or switch to a system for trading impulse moves. Professional traders, once
they find a technique that works for them, tend to stay with it. They’d rather
miss a trade than change to an unfamiliar style.
If a moving average is essentially flat, go long at the lower channel line,
sell short at the upper channel line, and take profits when prices return to
their moving average. The upper channel line marks an overbought zone.
If the market is relatively flat on long-term charts, rallies to the upper
channel line then provide shorting opportunities, whereas declines to
the lower channel line provide buying opportunities. Professionals tend
to trade against deviations and for the return to normalcy. Amateurs think
that every breakout will be followed by a massive runaway move. Once
in a rare while the amateurs are right, but in the long run it pays to bet
like the pros. They use channels to find when the market has outrun itself
and where it is likely to reverse.