Should You Trade Within a Channel or Wait for a Breakout?

Happy Friday!

This week’s question comes from Trevor, who asks:

On your blog, you often state you are waiting for a breakout from a channel before considering an entry. Do you recommend not to trade within the trend lines even if there is a potential 2R or 3R trade?

The answer to this question is highly dependent on two variables.

First, what’s your trading style? If you trade between support and resistance within a channel, then by all means, do that. As they say, if it isn’t broken, don’t fix it.

Second, is that channel a corrective structure or part of a larger impulsive move?

That second question is the key to trend analysis. Without being able to answer it, you’re going to struggle to figure out which side of the market you should be on.

Every trend is made up of impulsive and corrective moves. It doesn’t matter if you trade stocks, currencies, commodities or something else.

The time frame is also irrelevant here. A 5-minute chart will have similar impulsive and corrective phases to that of a 4-hour or daily time frame. Of course, it’s easier to identify these phases on the higher time frames in my opinion.

So the decision of whether to trade within a channel or wait for a break comes down to context. Where is the pattern in relation to the broader trend?

For me, I almost always wait for the breakout when trading something like a channel. I’ve found that these patterns are corrective more often than not. Most traders refer to corrective channels as bull and bear flags.

In this post, I’ll describe a simple 3-step approach you can use to identify the trend, spot a corrective pattern and look for an entry. I use the following process anytime I’m presented with a new chart.

Let’s begin.

Understanding the difference between impulsive and corrective moves is paramount to your success as a trader. A failure to understand and respect this relationship will make achieving consistent profits as a trader harder than it has to be.

To find and capitalize on market moves, you have to know whether buyers or sellers are in control. And if neither party has a firm grip at the moment, it’s usually best to stay on the sideline.

Furthermore, if you want to secure the most favorable entry, there needs to be a pattern in place to identify the breakout point.

That point where the market breaks consolidation and continues in the direction of the trend is the hinge between the corrective and impulsive phase of a market.

One way to do that is through the use of patterns like channels or wedges. Even a simple trend line can sometimes be the “line in the sand” between consolidation and a trending move.

So when I talk about trading a break from a channel, know that the pattern I speak of represents a correction. And if the market breaks that channel in the direction of the prevailing trend, that’s when we want to begin searching for a favorable entry.

Now let’s run through three simple steps you can use to find these patterns and take advantage of the transition between corrective and impulsive phases.

This first step trips a lot of traders up. One reason for that is that all trends are relative. For instance, an uptrend on the weekly chart may appear to be a downtrend on the 1-hour or 4-hour charts.

So which one should you follow?

To find the answer, you have to know your time horizon for holding a position.

Do you typically hold positions for less than a day? Or, are you more of a swing trader where trades can last for a few days to a few weeks?

If you’re the latter, like me, what I’m about to share will help immensely the next time you perform a trend analysis.

The very first thing I do when I open a new chart is to pull up the weekly time frame. In some cases, the monthly chart is easier to read, but the weekly is usually sufficient for this exercise.

I’m looking for any significant patterns or levels that can help me figure out what’s happening on the daily time frame.

Here’s an example of what I look for on the NZDUSD monthly chart:

Once I have this structure in place, finding the trend becomes relatively easy. When the pair is trending lower, I only want to look for selling opportunities. Of course, the opposite is true when the pair begins trending higher.

That’s an oversimplified explanation, but that’s the basic idea.

Once you have identified the major trend on the weekly or monthly chart, it’s time to look for corrective structures.

There are two types of patterns I use – channels and wedges.

One isn’t necessarily better than the other, but over the years I have come to favor channels. They can be useful in just about any financial market and carry a measured objective that can help in identifying a potential target.

Keep in mind, however, that there won’t always be a corrective pattern worth watching much less trading. Many times consolidation can be choppy and disorganized.

If that’s the case, it’s probably best to stay on the sideline and look elsewhere. Never force a level or pattern to fit. If it isn’t evident at first glance, it may not be worth the effort.

Using the NZDUSD chart again, here is a corrective pattern that could have been used to spot a breakout opportunity:

At this point, you have identified the major trend and found a favorable corrective pattern such as a channel or a wedge.

The next step is to look for an entry once price breaks the pattern.

But you don’t want just any break. First, it should be in the direction of the trend you identified in step one. If it isn’t, you may want to stand aside.

Also, it isn’t enough for the price to just pierce a level of support or resistance. If I’m trading a pattern on the 4-hour chart, I need to see a 4-hour close beyond the pattern in question. The same holds true for the daily time frame.

That’s important because a common piece of advice I hear is to place a stop order just beyond support or resistance.

In my humble opinion, that’s terrible advice. In a volatile market like Forex, using a buy or sell stop just beyond a pattern’s boundary is a good way to get whipsawed.

In other words, your order gets triggered on a spike in price, but the pair quickly reverses and continues moving in the opposite direction.

Instead, wait for the pair to close beyond the level on a 4-hour or daily closing basis. Once that occurs, you can begin watching for a buying or selling opportunity on a retest of the level.

Hopefully, you can now see the answer to the question that Trevor asked at the start of this post.

Although it’s perfectly acceptable to buy at support and sell at resistance, doing so within a corrective structure can be disastrous, especially if you’re betting against the trend.

In those cases, I’m only interested in buying a break of resistance or selling a break of support.

It’s all about momentum. Identify the trend, look for a favorable corrective pattern and watch for a breakout in the direction of the prevailing trend.

That’s my “bread and butter” process for finding attractive setups.

While you can and dare I say should buy from support and sell from resistance, when dealing with corrective patterns things are a little different.

I won’t buy or sell a pair that is trading within a wedge or even a bull or bear flag pattern. Instead, I wait patiently for a breakout to occur and then look to join the prevailing trend.

Making the distinction between impulsive and corrective moves is important. The impulse is the move that best represents the direction of the current trend as well as momentum. This is where the most money can be made in the shortest amount of time.

Corrective moves, on the other hand, represent consolidation and typically move against the major trend. During these times it’s usually best to stay on the sideline and watch for a breakout opportunity.

Once you can identify where the momentum is and spot periods of consolidation, you’ll know whether you should enter at trend line support or wait to sell the breakout.

If you can find and exploit that transition between consolidation and momentum, you’ll have a trading method that can offer highly asymmetric setups, which should be every trader’s goal.

I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.

To do that, I need your help.

Here’s what you can do to get involved and have your question answered in next week’s post:

1. Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
2. Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.