Intraday Channel Trading

Constructing a Channel Spread Trading Strategy 

Trading channels is a well known and often used trading technique. 

It’s based on the observed tendency of many financial instruments to set a direction and then maintain it for a period of time. A change of such a paradigm is often well connected with planned and unplanned macro economic events. 

A recent example would be the sovereign debt crisis in EU, lead by Greece. Once the information emerged many instruments shifted and reversed some of their existing underline trends. 

A channel is defined when an instrument’s price is confined between 2 upper and lower parallel bands. The lower line is considered support and the upper line considered as resistance. 

In order to claim a channel has formed we must have at least 4 touch points, 2 on the supporting band and 2 on the resistance band. The more points connected without material breakout, the stronger the channel will be considered. 

As you may already guessed we have 3 types of channels:

• Ascending – When the price action exhibits a positive slope with rising tops and rising bottoms.
  
• Descending – When the price exhibits a negative slope with falling tops and falling bottoms.
  
• Sideways – When the price does not exhibit a particular slope. This is combined with a mix of rising and falling tops and bottoms. Sideways movement can also be broken down again into categories:
  
  
  
  • Diverging Sideways – This is best described with a combination of rising tops and falling bottoms, such that the price action diverges, yet the overall pivot line remains roughly the same.
    
  • Horizontal – When support and resistance bands are parallel with each other but with minimal or no visible slope.
    
  • Consolidation – A combination of falling tops and rising bottoms, such that the price action converges towards the pivot. Equilibrium may be achieved momentarily.
    

Channel Trading Example Chart - GBP/USD Forex Market: 




Plotting a Channel 

There are many ways of drawing a channel. The first, and most common, is drawing parallel lines, using the naked eye, which try to connect as many touch points as possible according to the principles outlined above. 

A more scientific method would be to use linear regression to plot the pivot line and build the channel around it. There are three main methods of channel building that are based on linear regression:

• Standard Deviation Channel – Two lines can form a standard deviation channel if they are parallel to the linear regression trend line. These are usually set two standard deviations either side of the regression line.
  
• Standard Error Channel – The standard error can also be used, in place of the standard deviation. This is preferred by some investors. It is the standard deviation divided by the square root of the sample size.
  
• RAFF Channel - The distance between the channel lines and the regression line is the greatest distance that any one closing price is from the regression line.
  

See in the below example how the 3 lines appear on an intra–day GBP/USD chart. 





Building your Channel Trading Strategy 

There are countless ‘off the shelf’ strategies for channel trading but this article will provide all the ingredients for building your own custom channel trading strategy. 

From each section below you should pick the method that you find most suitable for your own trading style. Once you have determined which methods to use, you will have a comprehensive strategy that covers all the necessary aspects of channel trading. 

It is highly recommended with any trading strategy, be it channel trading or otherwise, that you back test your strategy using automatic tools such as E-signal or Ninja. This may demonstrate a potential flaw before you risk your own trading capital. 


Entering the Trade 

As mentioned, there are several methods for entering into a trade; you can decide to either trade with the trend, against the trend or even trade both. 

Trading with the trend is considered the safest method as it mostly enjoys a higher accuracy rate. In fact even when a channel is broken, breakdowns do have a tendency to recover at least to the bottom of the channel which can be an exit point for either breaking even or with a small profit. 

Another option is to decide to trade both ways; SHORT on a breakout from the upper band and LONG on breakdowns from the bottom band. 

The greatest benefit of trading both sides is that one may get lucky and hit a material reversal, i.e. it could be a catching the top of an uptrend channel switching to a downtrend or vice versa. These are the rare occasions when out of scale profits can be made. 

The third method would be trending only against the trend. Some traders see the sense in this but, personally, I don’t. 

One thing to note is that with a spread betting account investors can gain quick access to a range of financial markets and you are able to trade in both directions, i.e. trade either long or short. 


Exiting the Trade 

Many traders take the view that getting out of a trade is as important, if not even more important, than getting into it. When trading channel breakouts you have several important decision points. 

The first one is channel recovery, when the price either falls or climbs back into the channel. One should pay careful attention to the patterns developing around the boundaries and decide if this is the time to close the trade. 

The second important decision point would be the pivot line; pay extra attention to this point especially when trading against the trend as counter trend movement sometimes breaks around the pivot line. 

The third and last decision point would be the opposite boundary. If you have reached this point you should be deep in profit so it’s probably the time to play it right and secure the majority of it as realized profit. 


Entry and Exit Style 

The simplest way to enter and exit trades is to decide in advance how much you are willing to risk on a specific trade and work out the desired stake size. Yet, there are also more sophisticated ways to trade:

• Scaling In - When using this method you would usually divide your overall investment into 3 batches. A third is to be placed when opening the trade. The second third would usually go in after price recovered back into the channel and the final third would be added once the price crossed the pivot line and the direction of the current movement is confirmed. When the price target has been reached the whole position will be closed.
  
  This method allows the trader to increase their stake only when price action is going their way and by trailing the stops, the risk factor may remain the same despite increasing the overall stake.
  
• Scaling Out – When using this method a trader would place the entire stake when opening the trade and reduce his exposure as price action moves his way, locking in more and more profit.

Both trading styles are very much valid and investors can alternate between them they see fit. In my experience, Scaling In works out better when trading against the trend and Scaling Out delivers better results when trading with the trend. 


Capital Management 

One important trading rule that many investors follow is 'refraining from risking more than 1-2% of trading capital' on a single trade. 

Aside from this, it is also advisable to build a well diversified portfolio where some of the contracts act as a hedge on others. This is to reduce the risk of all your holdings running against you simultaneously as the result of an unforeseen event. 

For example, let’s assume one decides to open various long positions on the US Dollar against the Japanese Yen and the British Pound. 

Both Britain and Japan are net importers of commodities and, therefore, are susceptible to changes in commodity prices. A natural hedge against these would be to take short positions on the Australian and Canadian Dollars as these two countries are net exporters and will enjoy increased commodity prices. 

This is especially necessary when trading the FX markets as positions can be very volatile. In addition, remember that the markets are well connected and you should always try to quantify your real net exposure. This can be done by summing the LONG and SHORT trades you may have in multiple positions. 


Hedging and Net Exposure Example: 

Instrument	Direction	Size	Open	Stop loss	Distance
EUR/USD	SHORT	$100,000	1.255	1.28	250
GBP/USD	SHORT	$100,000	1.502	1.52	180
USD/CHF	SHORT	$50,000	1.0675	1.08	125
AUD/USD	LONG	$100,000	0.8413	0.835	83
USD/CAD	LONG	$50,000	1.066	1.06	66
EUR/GBP	SHORT	$50,000	0.82	0.826	6

Net exposure: 

Instrument	Exposure	Overall Risk (Pips)
USD	100,000	412
EUR	-150,000	250
GBP	-50,000	120
CHF	-50,000	125
AUD	100,000	83
CAD	50,000	60

You may observe that the positions which are placed to hedge any un-favourable movement have stop losses which are placed much tighter than the ‘main’ positions. 

This is so that once the market moves in the ‘correct’ direction we will be looking to remove the hedge, allowing us to enjoy the most of the current swing in the market. It is always important to revaluate your risk once some of the positions are closed. 


Stops and Limits 

Stop losses should basically be placed very near to the closest high for short trades and next to the closest low for long trades. In essence you need to pin point a price level where the view that a reversal is imminent invalidates. 

In the chart below we can easily see how the GBP/USD was range bound in a very clear channel. 





When a trade is going well there are two key points where investors should consider trailing stops.

The first is once the market has regained the channel and completed a corrective movement, many traders choose to trail the stop close to the peak, for short trades, or bottom, for longs, of the movement. 

The second trail should come into effect once the price has pierced through the top of the channel. This is where a trader must carefully control his stops and limits in order to optimize his exit from the trade. 

Unlike stop losses, which are strongly advised in any position, limit orders are something that many traders find they can do without. 

This doesn’t mean that targets should not be set, yet when the price is getting closer to the target area it becomes important to make judgment calls according to emerging patterns, momentum and overall market sentiment. 

Please note that not all stop losses are guaranteed. 




Good luck and happy trading 

Shai Heffetz 

(Original article written 9 July 2010). 


Spread betting carries a high level of risk and you can lose more than your initial deposit, so you should ensure spread betting meets your investment objectives. 

The contents of this report are for information purposes only. It is not intended as a recommendation to trade.  InterTrader  do not accept any responsibility for any use that may be made of the above or for the correctness or accuracy of the information provided. 

BP - Did they really lose 35% otheir value in just over a month ?

Warren Buffet once said - "Be Fearful When Others Are Greedy And Greedy When Others Are Fearful".

If you ask today most people if they are willing to buy BP (BP.L) shares they will give you a dirty look and kindly advise you to check in with at the closest mental health clinic. Most people are not what we would consider successful in  their investment they will usually buy a stock near the pick and sell around the bottom.

The reason for that are simple, we humans are driven by our emotions fear and greed. I would suggest for you to take a close look at BP's financial and think again if their current share price is justified or is it just that people are scared.

Let's look at the facts :

- BP's earning for 2009 amounted to over $243B ,their net income was $16.5B

- Their average net income for the past 5 years has been $21B

- Current Market cap is $122B which means a multiplier of 0.5 on earning and 4.5 on net income.

Let’s assume that the cost for BP to fix the problem and clean the bay will reach $1B and law suits that will take years to resolve will cost them another $1B . So over the next couple of years it means a 5% reduction in net income. Does that justify a 36% drop in share price ?

Another approach would be run a technical analysis exercise on their chart.

Share price dropped 36% since the beginning of the crisis forming a triple bottom together with October 08' and March 09' ,each time the bottom seems to inch a bit higher than the previous one. BP has held on to the 400p support twice in the last 2 years.

Let us assume that the BP is in a bearish channel we know that for every action there is a reaction ,Fibonacci retracement provide us with use useful clues on the target price for the corrective move.

The 23.60% the closest line which is the minimum and stand @ 471p  ,the 38% is @ 507 and the 50% which will determine the overall direction of the  trend is  far away at 536p.

I am not in any way advising if one should speculate on the movement just take a look at the facts and decide for your self.

Shai Heffetz
Head of InterTrader.com

Disclaimer
The comment in this blog is the personal opinion of the contributors and not InterTrader.com. The content does not constitute financial, investment or tax advice. You are advised to discuss your specific requirements with an independent financial adviser prior to entering into any bet. InterTrader.com is not responsible and disclaims any and all liability for the content of comments written by contributors to the blog, and the content of any third party sites linked from this blog.

Trading news

Trading economic calendar events

In this article we are going to cover 3 different techniques to trade market moving financial events. They each cover a different point in time relative to a particular event.

The first involves opening a trade prior to the announcement, the second considers trading the announcement itself and the third is based on the aftermath of the release. 

Before going into the specifics of each technique there are a few basic concepts which are common:

1.     The Trend is Your Friend – As a rule of thumb, I prefer a trade inline with the underlying trend. One exception would be a material breakdown, below the channel, in a bearish trend or a breakout, above the channel, in a bullish trend.

2.     High Risk Reward Ratio – As trading news carries a higher level of risk, due to a high possibility of slippage and extreme volatility, it’s recommended to go into trades with a risk reward ratio greater than 1:3 or even 1:4. When you are looking to open a trade you should attempt to determine where the current support and resistance levels are to establish where your own stop loss and limit order levels should be.
Therefore, in order for the trade to enjoy a positive expectancy, one should aim that the distance of the limit order level from the current price will be 3 to 4 times bigger than the stop loss level, hence a 1:3 or :4  ratio.

3.     Tight Range – Prior to the announcement it’s preferred if the market is trading in a tight range as this will confirm that traders are sitting on the sidelines, expecting the announcement.

Identifying the Trend and Assessing the Trade’s Validity

To establish the underlying trend and momentum there are a several indicators and overlays aside from price action that may assist you in your analysis.

The first thing I like to do is to observe the prices by using a candlestick chart and following the first rule of trending; rising bottoms for a bull market and falling tops for a bear market.

The second indication I look for can be derived from the daily EMA(87); the 87 period Exponential Moving Average applied to a daily chart. When the market is bullish you can expect the price to mostly hover above it’s EMA(87) and vice versa for a bearish market.

The third indicator is used to asses the current momentum in the market. Typically I use the MACD(12,26,9) and look for positive or negative divergence without any signs of engulfing.

In the next example, we are going to review the underlying condition in the Dow Jones industrial average (DJIA) prior to the March 5^th 2010 unemployment announcement in the US.

Observations:

-          The Market is in a bullish trend.

-          For July 2009 until January 2010, the market managed to stay above the EMA(87). In February it broke below this and only recently has it recovered back above it.

-          The MACD, as our proxy for momentum, suggests that the market is recovering from its recent breakdown as the MACD is diverging positively and has recently just crossed the 0 line.

In order to determine what the risk reward ratio is, you will need to find the potential market turning points.

As we are considering going long we would look for the closest support as a stop loss and the next resistance line as our limit. As explained before, we should aim for the risk reward ratio to exceed 1:3

In the chart, the Dow Jones is most recently trading around 10,400. Therefore, our profit target is 10,070 and our stop loss should be at 10,300. The profit target is 300 points from the current price whereas the stop loss is only 100 points away. As a result, our risk reward ratio is 3.1:1 which is just Within the positive return spectrum

Now let’s get to business and discover the different ways we can trade the news.

Can You Prophet?  

With this strategy we will be opening a position that reflects our view of the market approximately 30-60 minutes prior to the announcement. You should identify the current trading channel and try to get a position below the pivot line if you are going long or above the pivot line if you are shorting.

Your stop loss should be placed at a point where you believe is beyond the reach of a probable market dip or spike, i.e. outside the ‘stop loss kill zone’. If there is something worse than being wrong, it’s getting it right after being stopped out.

Therefore, your stop should meet the two important qualification criteria; it must be below the stop loss kill zone while still meeting the required risk reward ratio. If you cannot meet both of these then don’t get into the trade.

Holding the Stick Both sides

This technique is very different as you will not be taking a view on the market.

When using this method you will be placing two opposite limit-to-open orders that each have their own associated stop loss and limit orders.

You should get into this trade if you believe that there is a very high probability for this event to move the market but are not sure how it will play out.

This trade enjoys an increased probability in two circumstances. The first is when the price is close the top of a bearish channel, or the bottom of a bullish channel, and the news may determine whether the current channel is completed or will be re-established.

The second occasion is if, in the days or even weeks prior to the announcement, the market is contained in a sideways movement lacking any real direction. This is a suggested step by step list:

1.     Identify the current range the market is trading in.

2.     Decide if market conditions justify using this method. If so:

a. Place a limit-to-open long order above the upper bound of the range.

i.      Associate a limit order at the next resistance level.

ii.     Associate a stop loss order at around the bottom of the range.

b. Place a limit-to-open short order below the lower bound of the range.

i.    Associate a limit order at the next support level.

ii.   Associate a stop loss order at around the top of the range.

It should look something like this:

There are a few very important golden rules when attempting this sort of opposite orders trade. 

The long limit-to-open order should be above the stop loss level of the short limit-to-open short order including a safety distance in case the market slips. If possible I like to use guaranteed stops. The last thing you want is to find yourself in a fully hedged position after both your long and short orders are met but no stops are triggered.

There are two possible scenarios where you may incur a loss. Sometimes the market may decide to move one way when the announcement is released, or perhaps shortly before it, and then sharply reverses. In that case you may lose one of the positions and not benefit from the other.

An even worse scenario is if the market becomes extremely volatile and burns your stop loss on both positions. You can minimize this risk by researching the market in terms of volatility and reviewing how the market behaved in the past when the specific announcement was released.

The risk reward analysis mentioned before remains valid, it’s just that now you must make sure it works out both ways in order to validate the positive expectancy of the specific trade.

Are you sure this is where you’re going?

When using this strategy you should still adhere to the basic rules of conducting pre-analysis and determining your actions beforehand.

For example, if you were trading the Dow Jones on the back of a US unemployment news release, this is one decision making process that you could follow:

1.     Determine the current trend in the market.

2.     Consider current price in relation to the trading channel, i.e. is it a pivot, an upper boundary, or a lower boundary?

3.     Research the previous three releases and review:

a.     How the market reacted.

b.    The accuracy of the analysts consensus.

4.     Decide what would be your action plan. For example:

a.     If  current consensus is that unemployment will reduce to 9.7% then

                                          i.    If the actual number is 9.6% or below - LONG, Stop Loss - 10,000, Limit - 10,400.

                                         ii.    If the actual number is 9.9% or above - SHORT, Stop Loss - 10,200, Limit - 9,600.

Once you have determined your action plan you sit tight and wait for the news to be released. Hold tight while the market reacts.

At this point there are multiple scenarios. However, you only care about those which you have an action plan for and believe have a positive profit expectancy.

If the desired correlation between the released figures and the price action takes place then you should get ready. You should wait for the market to make its first move and retrace back. When the price retracement seems to be concluded, that’s when you open your position.

At this point in time the market has made its first move and confirmed the new direction and so the profit expectancy of this trade has dramatically increased.

Below you can find an example based on the May 20^th weekly unemployment report. Consensus expectations were for -446k when the market is trending down. The plan is that if the figure proves to be worse then expected it may fuel further selling and, therefore, short is the way to go. See chart below:

Summary

In this article we reviewed three different ways of trading financial news.

We started with an option where you take a stand prior to the release; this trade carries significant risk and yet offers the highest reward within a short time span.

The second one is unique in nature as you do not take a stand initially but you operate under the assumption that a range breakout will enjoy a continuation.

The third method encourages you to trade a trend continuation after an initial corrective move in the market. The most evident downside to this method is that you might miss out on the first big movement in the market. In this case, the retracement you are waiting for may never occur, or may take place at a much lower level where the risk reward ratio does not justify a trade.

It’s important to remember that, regardless of the strategy you employ, to research, plan and execute a trade only if the underlying conditions match your plan. Do not be tempted to trade just because you prepared for it and are looking for action.

Shai Heffetz
Head of InterTrader.com

Disclaimer
The comment in this blog is the personal opinion of the contributors and not InterTrader.com. The content does not constitute financial, investment or tax advice. You are advised to discuss your specific requirements with an independent financial adviser prior to entering into any bet. InterTrader.com is not responsible and disclaims any and all liability for the content of comments written by contributors to the blog, and the content of any third party sites linked from this blog.