Using Channels In Your Trading

07/17/2012 3:11 pm EST

Focus: STRATEGIES

Al Brooks, MD

Professional Trader, Author, Lecturer, Brooks Price Action, LLC and Brooks Trading Course

Al Brooks explains how he uses trading channels and transition phases to decide whether to trade the trend or scalp.

We are talking about trading using channels today with Al Brooks.  Now Al, you do have some thoughts about when to buy, and when to sell, when you are using channels.  Tell us about that.

Right, I view the market as either being in a strong trend or a trading range.  A channel is a weak trend, which is a transition between a strong trend and a trading range.  We have a breakout from a trading range, a strong trend and a spike, and then you start to get overlapping bars and small pullbacks. That's the channel phase.  Over time it evolves into a trading range, and trades back down to-if we are talking about a bull channel-it trades back down to the bottom of the channel. 

Let's talk about where to buy.  I also want to talk about where to short, but let's talk about where to buy.  Is the price ever so high within a channel that it becomes dangerous to buy?

Yeah, that absolutely is the case.  A channel is a transition. If the channel is very steep and vertical, with very little overlap between the bars, it is essentially behaving more like a very strong bull trend. When that is the case, you can buy at any point and manage it like a strong bull trend.  When it starts to get deeper pullbacks and bigger swings it is behaving more like a trading range. Then you can start to take trades in both directions, and it is usually better to trade it like a trading range. Looking to buy low, sell high, and scalp. 

So how about shorting, when is the best point at which to do that?

I would only consider-if we are talking about a bull channel-I would only consider shorting it once it has clear evidence that it is transitioning into a trading range.  In other words, I need to see the market go at least sideways for four or five bars, break to a new high, and then form some kind of minor reversal.  Since it is still a bull trend, I am only looking to scalp. So any short in a channel is only a scalp. 

Let's talk about using stops, because obviously that is one of the most important elements of a trader's strategy.  How do you use stops when you are trading channels like this? 

It depends on your objective.  If the channel is still very steep and very strong, I am looking to swing trade. Unfortunately, that means your stop goes below the most recent higher low, which can be far down. So if your risk is far greater than what you would normally want, you have to trade much smaller.  If the channel is starting to transition more into a two-sided market, and you are looking to scalp, your stop is going to be much tighter, but your profit objective is also going to be a lot smaller.

Now you were alluding to breakouts a moment ago.  Talk about how your trading might change if your stock breaks out to the top say?

It depends. I assess the strength of the breakout.  For example, if it is one bar and it is exceptionally large, and it closes near its high, the market probably will have follow through. So I could buy the close of the bar.  If the next bar also has a bull body, the odds of follow through on the next several bars is probably 70% or more. So again, I can buy the close, and use the stop below the bottom of the spike.  On the other hand, if the breakout bar has a big tail, closes down near the middle, and the range is not too big, I will wait before I buy. There is a higher chance that the breakout will fail. 

Well, very valuable insights today Al. Thank you so much.

You're welcome.

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