Why Trade Channels?
When you first see a price chart in the Forex market or any market, price appears random.
However, you quickly realize that there is a type of organization of price action based on the predominant players acting in unison. If that is in favor of selling the JPY or Canadian Dollar then so be it. All you need to know is that channels often play out and whether they are holding firm or breaking, they can be of great use to you.
Another key thing about channels is that they often develop on multiple time frames. This is great news because whether you are a position trader who may only hold a handful of trades a year or day trade the FX market, you will likely see channels on your respective time frame.
Did the Channel Hold Or Break?
If a channel holds, then consider yourself lucky because the parameters for your trade are as clean and clear as they can be. In a rising channel, you can buy when the channel looks to hold near the bottom 10% of the channel. It's always recommended to use a protective stop and when identifying and trading a channel, you can place your stop order to get you out of the trade below the recent channel low thereby protecting your finite capital source.
As mentioned in the Psychology of Holding A Losing Trade, you don't want to be on the opposite side of a breakout hoping the trade turns back in your favor. In that scenario, you've lost a symbolic tug of war battle with a gorilla and it's best to give the gorilla the rope and move on to the next trade.
The Key Point to Enter On a Channel Break
Trading on a breakout is tempting. However, breakout trading can be a costly time to enter as false breakouts often occur. You can take it from my pain in the earlier years of trading that major breakouts higher can occur when buyers are at their exhaustion points and the sellers are ready to plot a counter attack to drive price back down. When the sellers are ready to re-emerge and you've bought a recent high, pain both financial and emotional can follow.
Therefore, as opposed to entering on the breakout, which can pay off but is often riskier than necessary, it is better to wait. There are two technical developments that you can wait to form before entering in the direction of the breakout. The first and most common confirmation is for a close of the price bar that the breakout occurred. For example, if you follow daily price bars or candlestick charts, when a breakout occurs during the trading day, you can wait for a close above the point of breakout to confirm your trade. By waiting for the close, you at least know that the breakout held the conviction of the buyers into the end of trading that day and wasn't a flash in the pan type of breakout that will soon be reversed.
My preference when trading breakouts is to allow the channels that previously contained price to be tested again but in a different manner. On the USDCHF chart below, you can see that since 2013, USDCHF has been in a falling channel due to across the board US DOLLAR weakness but since the Federal Reserve announced their QE Taper, the USDOLLAR has shown strength and the USDCHF has popped higher. As a trader who always focuses on risk before reward, I want to see the price ceiling or top of the channel begin to act as the new price floor or support before the pair looks to move higher. USDCHF shows this well as after the first breakout faded by about 120 pips, then USDCHF regained its uptrend by bouncing higher off the old channel ceiling which clearly paints the picture for places to put a stop now on a buy trade.
Of course, if neither of these confirming scenarios took place, it's best to leave this trade and look for a higher probability set-up.