Exploring Trading Techniques Part I
Courting the Channel Breakout
The channel breakout is one of the first technical trading techniques we learn. The idea is that if the market is able to push out of a restricted range of price action, it is attempting to move farther in the direction of the breakout. Conventionally, the width of the breakout can be used as the distance to the target in the direction of the breakout.
Figure 1. The EUR/JPY breaks above a channel resistance at 109.60. The rally hits the conventional channel breakout target, using the width of the channel and projecting it in the direction of the breakout.
This sounds simple enough. But when you start using the trading rule, it breaks down, and you start to doubt the merit of this approach. This is like many relationships. It is exciting in the beginning, but then things become different from the way you pictured it.
Figure 2. Not all breakouts are created equal. Some are false breakouts only to do so in the opposite direction. Some are simply expanding or bending the channel. The top panel of the above charts shows a false bullish breakout in the AUD/JPY that immediately returned back into the channel, and eventually broke out on the downside. The EUR/GBP 15-min example shows that the channel between 4:30 and 9:30 on Oct. 29 expanded both ways after both a false bullish and a false bearish break. The market is also adjusting a decling channel by creating flatter resistance and support lines.
But then again, you look at the charts, and right there in front of you are fruitful channel breakouts in the past. If you look back at a relationship, you might realize that there were good times and bad. You have to decide if the good outweighs the bad, and whether it is worth persuing. If you see a future, you also have to figure out how to minimize the bad, and expand on the good.
If it does not work out, you will have to move on to another one. Find another trading approach, and see if you can make it work. The point is that exploring a trading technique is much like working on a relationship. If you see merit in a trading technique, you need to pay some effort and attention to figuring out if it is a keeper, and how you improve on the results. So is the channel breakout something we should try to work on or move away from?
Figure 3. Despite issues with the channel breakout in real-time application, we can see the merit of this approach in hindsight. Perhaps, we just have to ask the right questions.
Let's try to make it work. I am no love doctor, but I know that if you pay attention to your relationship just enough, you can really find little ways to improve it. It can become effortless because your mind reinforces the things you do that bring you pleasure and goodness, and when you start getting it right, things can become pretty smooth - and then have to check your pride. But let's not get ahead of ourselves just yet.
Why don't we go back to courting this basic trading approach. We already know what channel breakout looks like. Now let's think of variations of this signal. It is like taking notes on your partners temperaments under different circumstances. What is she like when she's around her friends; and yours? What is she like when you trade for 10 straight hours throughout the night? We ask these questions because 1. we want to know if she is a keeper. 2. if she's a keeper, what do I have to do to keep her.
If you are to court the channel breakout to see if it can become a permanent part of your trading strategy, you may want to ask the right questions:
Question 1: Is there a difference between a breakout in the direction of the trend as opposed to one against it? The mantra goes - the trend is your friend. Does this apply to channel breakouts? If this theory is true, do we abandon all channel breakouts against the trend, or should we find ways we can treat them differently?
Question 2: Does the strength or manner of the breakout make a difference? Some are done by a sharp decisive action, while some slow down and break out almost reluctantly. Intuitively, a strong breakout is decisive and therefore should be suggestive than an weak indecisive breakout. However, as you start to trade, you might realize that sharp breakouts give you poor reward to risk. We are going to have to deal with some trade-offs. Are you going to be okay with not having everything your way?
Question 3: What is the merit of waiting for throwbacks and pullbacks? This is another interesting question. On one hand, if you don't wait for a throwback/pullback you risk getting into a false breakout. On the other hand, if you always wait for confirmation, you will likely miss many opportunities. The AUD/JPY revisited above shows a non-confirmation for the bullish breakout, and a positive confirmation for the bearish breakout. You also have to think maybe there are situations where waiting is appropriate, while there are others when it might not be necessary. What are these conditions?
These are just 3 very basic questions, from which more refined questions are derived. Do you have questions you want to ask about the channel breakout? Do you have some observations you would like to share about this trading approach? Please comment below.
The channel breakout seems to be a very good approach, but we have so many questions. It's okay, take it slow and eventually you will be able to somehow incorporate channel breakouts one way or another. Love is patient.
Fan Yang CMT
Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analyses.
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