We considered a few aspects relating to the trend line in our previous class. To add value to this tool, another line is drawn parallel to the trend line that joins the peaks in the up trend and the troughs in the down trend. The result is the trend channel that adds greater depth to the trend analysis. .
To construct the more commonly used trend channel, begin by drawing a trend line, by connecting the troughs in an up trend and by connecting the peaks in a down trend. Next, draw a line parallel to the trend line by joining the troughs in a down-trend and connecting the peaks in an up-trend.
There are other kinds of trend channels constructed using statistical tools such as standard error channels, standard deviation channels and Raff regression channel. Of these, Raff regression channel is pretty handy for traders. To construct this channel, a linear regression line is drawn through a set of data for a specific time-period. Then equi-distant parallel lines are drawn on either side of this line in such a way that they touch the highest peak or the lowest troughTrend channels can be incorporated in trading in many ways. They primarily help in identifying the next support and resistance level in a chart. The upper boundary of the trend channel would be the area where an up-move can encounter resistance. Shorting would be a good idea as the price reverses from these lines. Similarly, buying opportunities would be available as the price bounces off the lower boundary of an up-trend channel.
If we consider chart1, the stock price moved within a trend channel between April and October 2007 with the upper and lower boundaries providing the resistance and support respectively. When an upper boundary of an upward moving trend channel is breached, it denotes an explosive move in the offing, at a steeper gradient; as was seen after October 2007 in Action Constructions. The penetration of the lower boundary in an upward moving trend channel denotes trend reversal. The reverse is true in a downward moving trend channel.
Another utility of trend channels is that they can be extrapolated to project the future targets for a particular move. The potential target of the up-move in Action Constructions from the March 2008 trough can be projected with the trend channel as shown in Chart 1 above.