How to profit from major market moves whilst avoiding painful corrections

Following the article Profiting from gold without the pain, several readers have requested further details on what Trend Channel Analysis is and how it can be used to profit from long-term movements in the price of an index or commodity.

What is Trend Channel Analysis & how is it used?

Developed by Berkeley Finance Instructor Richard Lehman, author of the book Far From Random, Trend Channel Analysis (TCA) is an innovative technical tool for analyzing broad market movements. By applying new rules to traditional trend channels Lehman has transformed them from an occasional chart pattern to a continually recurring methodology for tracking the price of an index or market.

The technique can be applied to different time frames to determine both major and minor directional changes in price, however it should be noted that TCA does not work consistently on individual stocks.

From the book Far From Random: “A chartist using TCA can follow a particular index on a continual basis, projecting the future likely path of a channel or the likelihood of a channel break or change in slope. That provides a virtually continuous stream of trading opportunities as well as long term assessment of the underlying for potential hedging strategies as well as strategic accumulation or distribution needs.”

TCA is an excellent tool for those interested in trend following as a style of trading, since it can be used to identify either a deceleration (flattening in slope) or a trend reversal (see recent Dow example here).

The trend channels used in TCA are continuous meaning that the underlying security or index is always moving within a channel, regardless of direction, time period, or volatility. These trend channels are always parallel to one another, and it is common for them to overlap such that the last leg of one becomes the first leg of the next.

In his work, Lehman uses three common levels of channels which are defined by their time frame. For the hourly time frame, which is good for tracking the price over a few hours to a few days, he uses a chart with 5-minute bars. To track movements over a few days to a few weeks he uses 60-minute bars, and to track price for months or years he uses daily bar charts.

The price moves within the trend channels from the lower boundary to the upper one, but not with any predictability since the price may bounce along one boundary line, touching it multiple times without moving to touch the other.

One of the most important modifications to traditional channel analysis is that channels frequently change direction, i.e. form corners. They also widen and become narrower as price movements dictate.

Those interested in the short-term can draw shorter term (mini) channels inside larger ones to build up a better picture of the price action, and it’s important to realise that a strong move by a mini channel can push out the boundaries of a larger channel without breaking it entirely.

Using Trend Channel Analysis to look at silver, copper & the NASDAQ Composite Index

The chart below shows the last six years of price action in the silver and copper markets and also the NASDAQ Composite Index. Each chart has trend channels overlaid on top as well as green and red arrows showing logical buy and sell points.

A 6 year (daily) chart of silver (Click on the chart for a larger version)

A 6 year (daily) chart of silver (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

A 6 year (daily) chart of copper (Click on the chart for a larger version)

A 6 year (daily) chart of copper (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

A 6 year (daily) chart of the NASDAQ Composite Index (Click on the chart for a larger version)

A 6 year (daily) chart of the NASDAQ Composite Index (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

Conclusion

Trend Channel Analysis is a very simple technical tool that can be extremely useful in identifying market trends, and as these charts demonstrate, TCA can be used even in highly volatile markets.

As a trend following tool TCA will not get you into a market at the bottom or out of it at the top, however it does tend to protect those who use it from big downside losses.

For more on this subject see articles tagged trend channel analysis.

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