Editor’s note: This is the second article in a three-part series on applying basic technical analysis tools to an investing strategy. Read the first.
They say that even a six-year old can spot a market trend. Identifying and trading with the trend can be as simple as connecting the dots and making sure you color, er ... trade between the lines.
Technical analysis is a mixture of art and science. There are plenty of mathematical formulas driving the myriad of technical indicators in your favorite charting package. Price channels and trading bands can visually define a market's path and help you stay on the right side of a trend.
An old market adage says “let your profits run, and cut your losses short.” Price channels and trading bands take the concept of the trendline one step further, with the aim of maximizing a trend-following technique.
Here are three questions that price channels and trading bands can help answer:
1. When Is a Market Breaking Out to the Upside?
Charting tools on the Trade Architect® platform allow you to draw price channels above and below current prices. A 20-day, or four-week, price channel can be used for a breakout trading approach. The simple rule of thumb is: a close above the top of the price channel is a positive signal, which can be a trigger point for a long entry.
Let's look at how a price channel can help pinpoint an upside breakout (see figure 1).
2. When Has the Trend Ended?
The price channel technique follows the trend and identifies when it’s over. The buy signal remains in effect until the market closes back below the lower price channel line. The close under the lower line marks the exit signal.
3. How to Pinpoint Short-Term Trading Spots
For investors looking for more frequent trading opportunities, a trading band can help identify extremes and short-term targets. The popular Bollinger Bands® indicator plots an upper and lower band hugging a moving average (generally the 20-day). Don't worry: in case you fell asleep in statistics class, the trading band concept plays out visually on the screen.
Once a market becomes overextended, either on the upside or the downside, trading action will begin to revert to the mean. Think of it this way: If you pull hard on a rubber band, it snaps back, and usually pretty hard.
Bollinger Bands can be used to identify short-term trading opportunities because once a market hits an extreme, trading outside the upper or lower line, a snap-back move usually ensues. Bollinger Bands indicator can help identify short-term trading spots (see figure 2).
The upper and lower Bollinger Bands lines tend to act as price resistance and price support, respectively. Generally, markets don’t trade above or below the upper and lower lines for long, as they tend to revert to the mean.
As a market hits the upper Bollinger Bands line and reverses lower, the first target is seen at the middle Bollinger Bands line. A close under the middle Bollinger Band line then sets up a second target at the lower Bollinger Bands line. Short-term traders can use Bollinger Bands to help identify a range-trading strategy that simply involves selling at the top of the range and buying at the bottom of the range.
Crayons and Profits
Trading with the trend can be a useful investing approach. Just like drawing in a kid's coloring book, if you stay in between a market's trendlines or channels, it may help keep the profits in your pocket.
Be sure to check The Ticker Tape® next month for part three of Charting Basics as we discuss another handy technical system known as Fibonacci retracements.
Charting a Course
Learn more about charting systems favored by professional traders in an archived webcast led by Jeff Bierman, TD Ameritrade’s chief market technician.