(This is the 14th article in a series of articles on basic technical analysis originally published in Futures magazine.)

One of the most commonly used concepts in technical analysis involves trendlines, as reflected in market axioms such as “The trend is your friend” or “Trade the breakout of a trend.” An uptrend line drawn along the bottom of a series of higher lows or a downtrend line drawn across the top of a series of lower highs is a rather simple but effective way to visualize price direction. (Of course, as with most areas of technical analysis, where you place the trendline can be a subjective art.)

In many cases, a trendline may make the overall trend relatively clear, but the price action is so erratic that it is still difficult to trade the trend. A more desirable market to trade is one in which prices stay within a well-defined channel marked by the trendline and a parallel channel line. The parallel channel line reinforces the validity of the trendline and represents the limit to which prices are likely to stray from that trendline. Price movement appears to be much more orderly.

This chart of sugar futures is not the best example of trendline channels because, ideally, you will want to trade a longer-term channel. However, this short-term example is in line with the fundamentals and with the larger-degree trends and illustrates a number of ways to trade trendline channels that have been identified early in their development.

1. Once you have identified a channel, sell near the top of the channel and buy near the bottom of the channel. Note: You will probably make mistakes in spotting “channels” too soon or too late, so it is important to use stops to minimize risk.
2. When you have two contact points for a trendline (A and C on our chart) and a point for a potential channel (B), you can envision a channel forming. Trade the breakouts of congestion areas in the direction of the channel. Frequently, continuation formations such as “flags” and “triangles” show up in channels. In this example, that would have meant selling when prices dropped below the low at B, especially since that coincided with an earlier low around 8.77 cents (D). Your stop would have been just above the high at C. The same concept could have been applied at the next low (E) although you need to be aware of when prices may be approaching “too low” for current conditions.
3. Trade the breakout of a trendline channel. On our chart, that would have meant buying the breakout of the downtrend channel at F and selling the breakout of the uptrend channel at I. These are the most visible signals in trendline channel analysis. In some cases, a breach of a trendline may not be a breakout at all but may just mean you have to adjust the trendline. Use stops to protect yourself (below the low on the breakout at F and perhaps at the trendline on the breakout at I).
4. If you do not get a position on the breakout, take a position on a retest of the trendline. Markets often come back to test a breakout of any chart pattern. On this breakout of the downtrend channel, that meant a buy stop in the vicinity of G. Again, you want to establish a protective stop below the low in case the breakout was only a pause in an ongoing downtrend channel. In some cases, there will be no retest, and you will miss a trade.
5. Take advantage of an extreme move outside of a channel to take profits on at least a part of your position – this assumes you have a multi-contract position, of course. Unless market conditions have changed dramatically, a move outside of a channel is often an emotionally charged event that causes an over-reaction in prices. The spurt above the channel line at H is an example. You might even decide to go short on this rally above the channel line, but this puts you in the riskier position of being short in a potential uptrend.

All of this analysis depends on your time frame, of course, because trendline channels, like many other areas in technical analysis, usually become much clearer in hindsight. In the bigger picture, the two-week, short-term uptrend outlined by F, G, H and I might be viewed as just a bear flag in a major downtrend, for example. Nothing in technical analysis can be considered in isolation.

Next week: Flowing channels