The channel line, or the return line as it is sometimes called, is another useful variation of the trendline technique. Sometimes prices trend between two parallel lines—the basic trendline and the channel line. Obviously, when this is the case and when the analyst recognizes that a channel exists, this knowledge can be used to profitable advantage.
The drawing of the channel line is relatively simple. In an uptrend (see Figure 4.16a), first draw the basic up trendline along the lows. Then draw a dotted line from the first prominent peak (point 2), which is parallel to the basic up trendline. Both lines move up to the right, forming a channel. If the next rally reaches and backs off from the channel line (at point 4), then a channel may exist. If prices then drop back to the original trendline (at point 5), then a channel probably does exist. The same holds true for a downtrend (Figure 4.16b), but of course in the opposite direction.The reader should immediately see the value of such a sit­uation. The basic up trendline can be used for the initiation of new long positions. The channel line can be used for short term profit taking. More aggressive traders might even use the channel line to initiate a countertrend short position, although trading in the opposite direction of the prevailing trend can be a dangerous and usually costly tactic. As in the case of the basic trendline, the longer the channel remains intact and the more often it is suc­cessfully tested, the more important and reliable it becomes.
The breaking of the major trendline indicates an impor­tant change in trend. But the breaking of a rising channel line has exactly the opposite meaning, and signals an acceleration of the existing trend. Some traders view the clearing of the upper line in an uptrend as a reason to add to long positions.Another way to use the channel technique is to spot fail­ures to reach the channel line, usually a sign of a weakening trend. In Figure 4.17, the failure of prices to reach the top of the channel (at point 5) may be an early warning that the trend is turning, and increases the odds that the other line (the basic up trendline) will be broken. As a general rule of thumb, the failure of any move within an established price channel to reach one side of the chan­nel usually indicates that the trend is shifting, and increases the likelihood that the other side of the channel will be broken.
The channel can also be used to adjust the basic trendline. (See Figures 4.18 and 4.19.) If prices move above a projected ris­ing channel line by a significant amount, it usually indicates a strengthening trend. Some chartists then draw a steeper basic up trendline from the last reaction low parallel to the new channel line (as demonstrated in Figure 4.18). Often, the new steeper sup­port line functions better than the old flatter line. Similarly, the failure of an uptrend to reach the upper end of a channel justi­fies the drawing of a new support line under the last reaction low parallel to the new resistance line over the past two peaks Channel lines have measuring implications. Once a break­out occurs from an existing price channel, prices usually travel a dis­tance equal to the width of the channel. Therefore, the user has to simply measure the width of the channel and then project that amount from the point at which either trendline is broken.
It should always be kept in mind, however, that of the two lines, the basic trendline is by far the more important and the more reliable. The channel line is a secondary use of the trendline technique. But the use of the channel line works often enough to justify its inclusion in the chartist's toolkit.