Descending Channel – Learn How to Trade This Common Pattern
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What is a Descending Channel
A descending channel consists of two parallel lines that are equal distance apart and surround price action.
Are you confused yet? Well, a picture is worth a thousand words.
What are some of the things you notice right away when reviewing the chart?
A couple of items that jump out to me are that you need at least two points that you connect the line to start the channel. In this case, it's the lines at the top of the channel, which have the red arrows pointing to them in the image.
Next, you will notice that the bottom of the channel runs from the low point of the gap up candle (large green candle in the chart). Notice how price stays within this channel as the stock EA marches lower.
How to Trade Descending Channels
There are multiple ways you can trade descending triangles. Now, each method will require a different trading style and preference, so you will need to see if one or any of these approaches work for your trading style.
#1 - Trade the Breakout
One method is to trade the breakout of the channel. This breakout can be to the upside, but also to the downside. This setup is going to be the toughest of the three to trade, due to the false breakouts which occur in the market at a high frequency.
Breakout to the Upside
A breakout to the upside means there is a possible shift from a bearish sentiment to bullish. This strategy will have you buying the break above the channel. It's recommended that buying into this break should occur after multiple tests of the upper channel line. Reason being breakouts early on in the channel often lead to traps as shorts push the price of the stock back down to the lower end of the channel.
Breakout to the Downside
The breakout to the downside is again often overlooked as a method for trading this setup. A break below the lower trend channel line is a signal that the stock is experiencing significant weakness. This likely means the channel is now expanding and there will be a new lower channel line.
I know this sounds a bit ambiguous, but this is trading. The market is going to do whatever it wants and you need to be prepared to handle the action.
As you can see in the above chart of ARLO, after trading in a down channel for a few hours, the stock broke to the downside shortly after 10.
Stocks that breakout in the early morning session have a greater likelihood of following thru on the breakout. In this example, after hugging the oversold line for a few candles, ARLO broke thru with a vengeance.
#2- Short the Test of the Top of the Channel
Channels are better suited for traders that place trades within the range. The top of the channel is also known as the overbought territory for all of you Wyckoff traders out there.
This means that as a stock approaches the upper channel, there is a high probability of price returning inside of the channel.
For this strategy, you will place your sell order at the top of the channel and then cover your position as the stock moves in your favor. There is no guarantee the stock will make it all the way back to the support channel, so you need to be prepared for anything.
Also, the price action for stocks trading in channels is often slow and boring. Therefore the trading action will appear erratic at times as price marches to its own beat. This will give you a number of false signals, and head fakes as the action plays out within the channel.
This is why again it's better to cover as things go in your favor and remember to exercise patience.
In the above example, notice how CLDX tests the top channel and rolls both times. The more touches you have in the channel, the greater the risk of the stock breaking out.
It's like anything in life, the more tests of something, at some point it's going to break.
#3 - Buy the Test of the Bottom of the Channel
Buying the test of the lower portion of the channel can get tricky. This is because you are knowingly buying a stock that is in a weak position. Therefore, you need to tread the waters with caution. Doesn't mean you can't take action but you have to be prepared that the stock may not bounce and could just ride the lower portion of the channel lower with no reaction back to the top line.
As you can see in the above example of EGHT, there were a number of buy opportunities, but there was only one that had a nice run up to the top of the channel. As you can see, there are setups, but you have to size them up appropriately.
Placing Stops with a Descending Channel Setup
Like any other trading setup or strategy, you need to enter stops. This will protect you from the unthinkable.
In a channel trade, your stop is determined by the strategy.
For breakout trades, you want to keep your stops beneath the top of the channel.
Channels Can Bore You to Death
We do have to talk about the fact that trading channels can bore you to death. What I mean by this is that the action in a down channel can be slow.
This means as you are observing the action, you should not overreact to one red or green candle. The stocks will generally hit one of the lines, but the move to the line is not linear.
Multiple Channels on One Chart - Which One Takes Priority?
As you are trading a channel let's say on a 5-minute chart, there could be another channel that you run up against on a larger time frame.
So, what do you do?
For me, I am aware of the overhead resistance, but as a day trader, I do not react before observing the price action. If it begins to stall, I know the traders monitoring this channel are in control.
If the stock slices through this channel with ease, I know that the channel I am observing on the shorter time frame is in control.
False Breakouts in Descending Channels
If you are day trading, descending channels will materialize in the middle of the day. This is because the pattern takes time to develop.
Remember, the pattern needs the back and forth which is the makeup of the middle of the day trading.
The challenge with this pattern is midday trading is notoriously difficult and boring. With the lack of activity comes the risk of making a bone head move.
So, as a day trader, you need to decide if this is something you want to do with your day. Remember, it's okay to just say no.
See How Tradingsim Can Help
Descending channels are a common trading pattern in the markets. If you are looking to make some trades on both the long and short side you have that option.
Remember, in descending channels the bears are in control, so if you go long, tread lightly.
You can always take a spin of the Tradingsim Platform to see if descending channels are a good fit for you.