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(AUDINDesign/Getty Images/iStockphoto)

Technical Analysis

The 'channel bounce' trading strategy, explained Add to ...

The S&P 500 SPDR is within a broadening wedge formation since the start of March, and bounced off the lows of that formation on April 8. A continued rise in the index toward the highs at $187.70 will favor these stocks bouncing off their own channel support lines. These four stocks are all moving within strong trend channels, and currently near channel support. The support line provides a potential buy area, with the resistance line – top of the channel – providing a target.

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The targets provided below are based on the current top of the channel. Over time the channel is rising, so if these trades last weeks or months, the targets will slowly creep up as the upper channel line rises.

The current trend channel in Brocade Communications has been in place since December. The stock dipped below $10 briefly on April 7, which was a test of the channel bottom. So far the channel has held, providing a buying opportunity between $10 and $10.30. A stop can be placed below $9.85, with an upside target near the channel top at $11.

Covidien has been moving in a $5 channel (approximately) since October. The stock is currently falling aggressively toward the lower channel line; if that selling strength continues, buying isn’t recommended. Though, if the stock slows its decent between $70 and $69, that is a different story. A pause and then a bounce near the trendline is ideal, providing an entry between $71 and $70 with a stop below $69. Target is the upper portion of the channel, between $74 and $74.75.

One thing to be wary of is that the channel is slightly converging, in a wedge pattern. Wedges are often followed by a reversal. A strong break below $68.50 indicates this scenario could be underway.

Qualcomm is currently near the middle of its channel, but short-term momentum is down, signalling the price could soon test the channel bottom. If the price slows and reverses between $76.50 and $75.75, buys can be initiated in that area or slightly above. A stop can be placed just below the newly formed bottom (yet to be determined) or at $75.50. Target is the top of the channel, which is currently near $81.75.

The trend channel in Consol Energy is less angled than the former stocks mentioned, indicating a bit more hesitancy on the part of the buyers. That said, the stock has been swinging well within the channel. Both the upper and lower channel lines have been penetrated a number of times. That will make the entry and exit points within stock more subjective, as the entry and exit areas will be slightly larger than normal.

Currently, the stock is near the middle of the channel, so it may take some time before an entry signal occurs. The entry area is currently between $39.50 and $38.50, but that entry area will rise slowly over time. A stop can be placed below $38.20, or a new low once it develops (yet to be determined). Target area is $42.10 to $42.65.

The bottom line
Trend channels provide a visually appealing way to spot trading opportunities. The structure of the pattern highlights the buying area (support), the target area (resistance) and stops are placed just outside the pattern. Ideally let the price pause and bounce at the lower trendline. This shows the selling has slowed and buyers are stepping back in. If the price bounces too aggressively off the channel bottom–say to the middle of the channel–leave the trade alone, as the risk is now likely to exceed the diminished reward. The goal is to get in near the channel bottom, and ride the wave to the top.

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