How to assess a channel trade
...and analyse its viability in terms of risk versus reward
This clip is an excerpt from ALAN HULL TV which is a weekly video newsletter. For more information click here
Alan reviews a stock market chart of BHP using technical analysis and assesses a channel trade present in the price action.
Looking at a daily chart of BHP (see above) it is pretty obvious that the price is trading in a channel, it is moving sideways in a band. Putting in some rough horizontal lines highlights the chart pattern. It is best not to be too finicky with your line placement, simply put them in to highlight the pattern that you see.
The price has come down and bounced off the lower boundary at about $35 and is starting to head back up. It is likely that the price will continue on up to the upper boundary of the channel. On that basis the trade could be entered right now.
Set the target at about $38 - this is down a bit from the resistance level at at $38.50. Don't count on it getting right up to the resistance level. It pays to be conservative in these sorts of short term trades.
Set the down side stop loss at about $35. Again, this is a conservative level - down a bit from the bottom of the channel to give the price a bit of room to move.
So if the trade was entered at this point you would exit the market if the price closed below $35 or if it touches the upper target at $38. You wouldn't stay with the trade because it is not a trend trade but jump out if the price hits the target.
In terms of the viability add a mid-line to the channel. This line represents critical mass for the trade. If the assumption is made that half our trades are winners and half loses then we need to make more money of the winners than we lose on the losses to come out ahead.
Therefore the mid-line becomes the limit for an entry. Entering above the mid-line makes the potential reward less than the downside risk. And because that is where the price is at this point this trade is considered marginal, not a great proposition in terms of risk management.
Trade viability calculation
Assuming a 50% win rate the Reward must be greater than the Risk (Reward > Risk) for the trade to be considered viable in terms of risk management.
Several weeks after the chart analysis the price moved in the anticipated direction and reached the upper boundary. However, at the time of the analysis the trade was not considered a viable proposition based on a risk assessment.