“Are you thinking straight?” If I had a dollar for the amount of times I heard that asked of me, I wouldn’t need to be in this business. The saying however holds true in the financial markets. Put a trendline on a chart to see what I mean. It is an inherent property of human nature that we think in a serial, one thing after another thing manner. In other words, apart from the few true lateral thinkers, we generally think in straight lines.

Married men should be nodding their heads right now, or at least wondering where they have heard this before? Remember, we supposedly can’t do more than one thing at a time (clearly no one has seen us with a remote, a can of coke and four sport channels).

What if you ask someone what is 2 plus 2? .. the answer you would usually get is 4. Correct of course … if we think of it in a linear fashion;

The thing is, 2 plus 2 also equals 8 divided by 2, 6 minus 2, or 3 plus 1. They all equal the same thing, yet the natural thought process takes us to the linear, straight line answer of four rather than think of alternate answers. Straight line thinking is the simplest and most efficient type of thought, and in trading, efficiency is encouraged as to not miss opportunity (questionable advice).

The commonly taught method of developing an entry in a trading system follows the same linear process.

Lateral thinking is not something commonly taught. It is about discipline, removing emotion and following your “system to the letter”;

“plan you trade, trade your plan”

This might go part of the way to understanding why straight trendlines appear in otherwise zig zag market. It might also be why trading channels can be so profitable. It is also might have bugger all to do with anything but let’s go with it for now.

The basis of channel trading is simple in theory. First find a trendline, then create a copy of the trend line and place it above or below the original trendline to create a parallel channel:

The USDCAD pair on Friday produced a nice little channel trade, here is how it was constructed:

1. The first pivot the trendline was based off.
2. The second pivot that formed the trendline, allowing us to draw the straight line.
3. The trendline created from points 1 and 2 was duplicated, and moved to the pivot between 1 and 2.
4. The first trading opportunity, as price extended back to the top of the channel, a bearish engulfing candle provided a signal the channel was to hold.
5. This was the last data of the day before the weekend close, but now we are on the other side of the bottom of the channel, and looking like a possible back side slap.

Trading channels doesn’t need to stop there however, what if price moves straight through the channel, or fails to reach the top of the channel, do we throw it away or do we look at other possibilities? Rhetorical questions really:

1. First pivot of the original trendline.
2. Second pivot to form the trendline.
3. The trendline duplicated and projected from the intermediate pivot, creating our channel.
4. Price has moved through the channel, but that doesn’t mean it is of no use. Duplicating the original channel and projecting it above provides a new channel which halted price.

While the original channel didn’t hold price to the upside, the nature of the original move wasn’t lost, as duplicating the channel above the original proved.

Any line you draw on a chart, whether it be a trendline, a channel, a triangle or a diamond, they are all providing a summary of the nature of price in that specific period of time, and projecting it forward. Basically saying, if price moved like this here, then if nothing changes drastically, it should still be acting the same way over there.

Just like you project forward, i.e. to the right of the chart, you can also project upwards, sometimes with scary accuracy. The advantage of projecting techniques is it provides something in advance, something to lead price rather than lag it which is always the major critisism of anything that required calculation.

There is one proviso with this technique (at least one I will mention), you will note that all projections has you taking trades against the current movement of price in that timeframe. This would seem to fly in the face of using the trend as your friend, but remember, there are many trends, on many timeframes.

If the long term trend is down, then an up sloping channel is the one to look for on a lower timeframe. Trading one of these in a bear market can provide great, low risk entries, and can also correspond to long term flag formations, one of the more reliable chart patterns around.

Channels can be a great tool in your trading tool belt, just remember to look at what context they are forming in.

• Channel Trading In Practice
• The 800 Pip Trendline