8127.Channel Surfing Riding the Waves of Channels to Profitable Trading by Michael Parsons

Channel Surfing Riding the Waves of Channels to Profitable Trading

by Michael J. Parsons

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1663 £tHER7Y DRIVE, SUITE 200 BLOOMINGTON, INDIANA 47403 (800) 839-8640 wwW.AUTHORHouSE.COM

© 2005 Michael J. Parsons. All Rights Reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted by any means without the written permission of the author.

First published by AuthorHouse 03/16/05

ISBN: 1-4208-3312-X (sc)

Printed in the United States of America Bloomington, Indiana

This book is printed on acid-free paper.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi­ cally disclaim any implied warranties of merchantability orfitness for a particular pur­ pose. No warranty may be created or extended by sales representatives or wrillen sales materials. The advice and strategies contained herein may not be suitable for your situ­ ation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. It should not be assumed that the methods, techniques, or indicators presented in this book will be profitable or that they will not result in losses. Past results are not neces­ sarily indicative of future results. Examples in this book are for educational purposes only. This is not a solicitation of any order to buy or sell. The National Futures Association (NFA) requires us to state that "Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under or over compensat­ ed for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve proi f ts or losses similar to these shown."

To my mother Peggy whose legacy still impacts this world for good more than a quarter of a century after she left it and my wife Ruth who stood by me through all the good, the bad and the ugly this world had to offer.

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Table of Contents 1.

Channel Surfing - The Basic Concept . .

2.

Break ing Waves

3.

Kiss of the Channel Line

4.

Major Price Levels

5.

Determining Balance Of Power

6.

Doing the Math - Setting Stops and Calculating the Waves

7.

Multiple Time Frames

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II. Putting It All Together

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True Support and Resistance

]0. Trading Options

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8. The Repeating Channel and Trend Angle 9.

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Introduction Trading is a blessing and a curse. It is a blessing in that no other occupation can be more exciting and rewarding than trading. You literally can become a mill ionaire overnight or at least in a very short period of time. On the other hand, trading is a curse because it is more likely that you will make someone else rich long before you have any real success. It is without a doubt the most expensive education you can obtain. In the process of educating yourself it can destroy your marriage, your retirement, your home ownership and many other things that take a lifetime to acquire. Poor money management, inability to control one's emotions and a clueless approach to trading leads many down the road to the poor house paved in fool's gold. It may look great to walk on, but who really wants to go there? My own introduction to this blessing and curse came from a man in a cowboy hat that made trading sound like child's play. Very quickly I realized that I was in over my head and that this man probably would have sold me the Brooklyn Bridge if given half a chance. Since then I have hit rock bottom twice while trading. (A nice way of saying I lost it all) After my last fiasco, I decided since I couldn't find any method that worked to my satisfaction, that is a method that actually made money, I would discover one for myself. This lead to a number of observations and discoveries of how the market works, why it behaves the way it does and more importantly, several methods that actually work that are based on the geometry of the market. Channel Surfing is one of those methods, providing an in-depth understanding of the markets that you will rarely find elsewhere. As you read this book you can expect to learn the following: The basic concepts of Channel Surfing, presented i n a way that is easy to understand and easy to apply. 2. Why channels are a natural phenomenon and how to take full advantage of this. 3. How to take the basic concepts of Channel Surfing and catapult it into an even more powerful method of trading using advanced techniques. 4. Additional tricks to reading the geometry of the market that add to your success. 1.

IX

While there exists an endless array of indicators available to use in this day and age, most have one common fail ing; they fail to adapt to changing market conditions. Channel Surfing succeeds in adapting to market conditions because channels are actually weaved by the market itself. Price rarely moves in a straight line, therefore channels provide the ultimate momentum indicator. Despite its adaptability, Channel Surfing continues to outperform many of the most popular indicators in use today, time and time again. The beauty of it is that it doesn't require you to suffer through large drawdowns in order to realize a profit. I n fact, it is so effective that it is probably the very best approach for beginning traders and those with very little capital. So just imagine what an experienced and well-funded trader can do with it! Although a parallel is made with actual surfing, this is a methodology that is about something very serious, trading profitably. But obviously the more success you have and the greater your confidence in your ability to extract a profit, the more pleasurable it becomes. Success and confidence are directly influenced by your ability to understand the market that you are trading. To that end each chapter of this book will take you step by step through the process of reading the language of the markets. Put into practice an individual can look at a market and recognize how it is likely to behave and react to the various situations that arise, a skill that often takes decades for a person to develop. Chapter one begins by covering the basic concepts of Channel Surfing, with nineteen illustrations that make it easy to comprehend. Five different entry methods are covered, along with two exits. These basic concepts alone can dramatically improve a person's trading success, but this is only the begi oning. Chapter two describes several specific entry methods that enhance the basics and provides more opportunities to enter a market with low risk. Chapter three delves into an important price phenomenon that can be exploited for profit. It also takes a closer look at the psychological aspects of trading and how they impact success. Chapter four examines major price levels, which include much more than just support and resistance. M ajor Price levels impact how trading decisions are made and can even contradict normal guidelines, so they are discussed in detail.

x

In chapter five the balance of power is discussed. What is the secret to knowing the bias of a market? The answer is detailed here from the most subtle indications on up to the larger and stronger signals. The math of Channel Surfing is covered in chapter six. Calculations are a requirement if you want to provide specific entry and exit numbers to a broker, but they also provide several other advantages as welL. Chapter sevcn elevates Channel Surfing to another level by using multiple time frames as a basis for trading decisions. This one technique will dramatically increase the odds of success in any trade you consider. Chapter eight brings a series of additional techniques to the table that enhances trading even further. Simple and effective, they provide additional tools to your trading arsenal that will cut down to size any market that is stubborn ly refusing to be analyzed. Chapter ninc is a real eyc opener and after reading it you will never look at a chart the same way again. True support and resistance flies in the face of traditional technical analysis, but it has proven itself time after time. Practically every consolidation pattern, reversal and acceleration can be understood and even predicted by using this invaluable method of reading a market. In chapter ten options are discussed. Options offer a great opportunity for profit if you can accurately identify where a market will go and when it will be therc. How to determine these key factors are outl ined. Chapter eleven brings everything together providing several trading examples that show how to effectively use these methods. A sobering look at the reality of trading is discussed, as well as some additional factors that will impact trading success. The techniques and methods discussed in this book provide a complete trading plan that improves as the skill of the user improves. More than what is needed is discussed so that an individual can adopt what fits their particular style of trading. But initial ly the most conservative techniques should be utilized. For example, some entries described in this book can be very aggressive and have been identified as such. While such high-risk entries are at times discussed, several that are low-risk are emphasized throughout this entire book that will provide plenty of profitable trades without the need of such aggressive tactics. So initially focusing on the conservative techniques is strongly encouraged. Xl

Channel Surfing is a solid foundation for understanding the language of the markets. Even though my research has led to other advanced and powerful trading techniques, I still return to Channel Surfing whenever I first look at a chart. I am convinced that it will become your first and favorite choice when you look at a chart as well. For all its simplicity it remains an exceptionally powerful technique because it keeps losses low and profits high. I wouldn't trade without it. Besides, what could be more fun than surfing? Especially when it is profitable!

Xli

Chapter One

Channel Surfing - The Basic Concept A surfer surfing a wave, a sailboat sai ling with the wind and a glider soaring an updraft all have one thing in common. They catch and ride natural forces in motion. Yet, a surfer has no more control over a wave than a sailboat can direct the wind. They simply take advantage of forces that already exist for their benefit. It is no different for a trader. During the course of a long and successful career in trading an individual will weather many storms and lulls in the markets and face many updrafts and down drafts. No one can dictate how the market will act, but that doesn't mean that we can't learn how to take advantage of the forces that develop. Have you ever seen what a surfer does when a storm brews? As a storm hits a coastal area most beachcombers wil l avoid the beach. But a surfer sees this as an opportunity and they will come out in droves l ike sharks circling bait in hope of surfing larger and better waves. In a sense, trading is the same because a market storm can result in some wild swings and potential ly offer an exceptional ly high return. For an inexperienced surfer, such a storm could mean a wipe�)Ut just as surely as a stormy market often does for an inexperienced trader. In contrast, a storm for an experienced surfer can mean the ride of his life, just as a wild market can mean a windfall for an experienced trader. In many ways the market behaves just like the waves of an ocean, so forming a parallel between a surfer and a trader is as natural as a wave breaking along a beach. The similarities between surfers and traders are

Michael 1. Parsons

uncanny. A surfer will wait until he finds the best wave, time his entry, ride that wave as long as he can balance on it and then go back out to catch another wave. Guess what a successfu l trader does? He waits for and chooses the best market, times his entry, rides that market as far as he can manage and when the ride is over he starts the whole process all over agam. Throughout this book you find many references to the simi larities that exist between surfing and trading. But in all seriousness this book is about a trading method that actually works and has proven to be one of the easiest to learn, easiest to apply and easiest to fol low. Particularly if you are a beginning trader or have a very limited budget you will appreciate how this method overcomes your limitations by providing you with low risk and high return. The analogy to surfing serves to give you a visual aid to understanding what it takes to be successful in trading. But where a surfer surfs the waves strictly for fun, you will be surfing the market for both fun and profit. So how do you surf the markets? Visualize for a moment a surfer surfing a wave. He rides a flat board that he balances on the cascade of a breaking wave. I nitially, he sets up where waves first break at what is known as the impact zone and makes a wave (catches a ride), and balances for as long as he can until the wave finally collapses on itself just shy of the beach. Once the wave dies and slips away from under the surfboard, the ride is over and its time to set up for the next wave. Channel lines act as your surfboard and price your wave. As long as your surfboard rides the price wave, then you just have to keep your balance and enjoy the ride. When price slips away from your channels then the ride is over and it is time to set up for your next wave. In other words, Channel Surfing uses channels to set the parameters for price movement. For those of us that are mathematically impaired, this is a graphical way to determine what the market can be expected to do and not do. The value of this is that if it exceeds these parameters then you are alerted to a change in a market's condition and the need to make a change in your trading. Here is how it works: Once a market is moving, you draw a trend line fol lowing the edges ofthe price bars using the highs or lows as your gauge. Normally, you will need to have at least two highs or two lows to draw your l ine from and the more highs or lows to work with, the better. But it 2

Channel Surfing

is not a matter ofjust finding the most bars, but rather the bars that outl ine the extreme of price activity. So there may only be a few bars to work with, particularly when a trend is new. However, as a rule the greater the number of bars that support a trend l ine, the stronger these l ines will be. On the other side of the price movement you also draw a simi lar trend li ne and thereby, create a channel . In effect, you put a fence around the price movement and provide a visual range parameter. Each price bar that fol lows should be within that channel and whenever you see a price bar exceed one of those channel l i nes then you know it is time to take action. The highs and lows you draw to create a channel should enclose all the price movement, so you are looking for the extreme highs and lows that fol low a singular direction. For the length of this book I will be differentiating between these two l ines by referring to them as an outside l ine or inside line. By definition, the inside line is the channel line that is always to your right, whether the trend is up or down. The outside line is the channel line that is always to your left. So if you have an up trend, the inside line is the supporting line, while the outside line is the resistance line. In a downtrend, the roles are reversed and the inside line is now resistance whi le the outside l ine is support. Notice in Figure 1 - 1 how the channel is drawn and that there is an inside and outside line that will reverse roles depending on whether you are in a bull or bear market (up trend or down trend)

The extreme swings of a trend are used to define a channel

3

Michael 1. Parsons

What if the market happens to be i n a sideways pattern? The principles are the same with one exception; channel l ines are drawn horizontally rather than diagonally. When the channel lines are horizontal there isn't any inside or outside l ines. So i n this case the channel lines are simply referred to as the upper and lower channel l ine. Figure 1 -2 demonstrates how this is done.

Lower Channel Line

QQQ 1 Minute

Exiting with channels

So now that we have a basic concept as to how to draw our channel, how do we use it? Success in trading depends on putting the odds i n our favor. By this I mean that we want the odds favoring that the market will go in the direction of our trade. But we also want the odds favoring profit over loss; that is we want our losses to be small and our profits h igh. As in any game you might play success in trading isn't about making all the points but winning more points than you lose, or in real life terms, winning more dollars than you lose. Putting the odds in your favor is not a matter of luck, but a matter of evaluating the risks, determining what the odds favor and then taking the position that is favored to win. The channel is our guide for evaluating our risk, a basis for making our trading decisions and for weighing the odds of any trade. As long as price remains within a channel and moving our way, then the odds are in our 4

Channel Surfing

favor. But as soon as price extends outside a channel the situation has changed and so have the odds. It is now time to exit. Exiting is a key component of Channel Surfing and it happens to also be a key component of successful trading. Initially, most traders want to focus on their entries, thinking that if they enter well then they are bound to make a profit. While it is true that entries can make a substantial impact on any trade the reality is that exits have an even greater impact. An entry only deals with one thing in your trade, the starting point. But exits incorporate two elements, the avoidance of unnecessary losses and the locking in of profits. Just consider one exit fault that can sabotage your success; exiti ng too soon. I f you exit too early such as just before a market starts to move in your favor, then it doesn't matter how great of an entry you make because you stiII take a loss. I n l i ke manner, if you exit before a trend has a chance to finish its run then you miss out on a large part of the profits. A bad entry can mean a small loss, but a bad exit can mean a financial disaster. So if exits arc one of the most important aspects of trading then it is essential that we understand how to determine our exits properly and when to exit. So for the next few moments we will be examining how Channel Surfing determines exits. Trends tend to offer some of the best tradi ng opportunities in trading, so we will look at one in our first example. I magine that you have shorted or sold a market that is in a downward trend. The trend has established a wel l formed channel that the market is fol lowing perfectly. Suddenly the market slows down and extends through the inside channel Line and price bars start to close beyond it, breaking the channel. When this happens the first rule of Channel Surfing is to get out as soon as possible because this signals that the market has changed and likely will extend into a sideways pattern or possibly reverse direction entirely. Take a look at Figure 1 -3. In this chart example I have entered a trade by shorting (selling) a contract at the point it breaks a support l ine. As it drops, channel lines are drawn. Later, the market extends beyond the inside channel line and an exit is signaled.

5

A4ichael J Parsons

An exit is signaled when the market breaks out of the channel - Its time to lock in the profits!

A short is taken when the market breaks an inside channel line and holds

Hewlett Packard

The signal is relatively simple, break the l ine and you exit. To clarify this a l ittle, you are looking for an actual break and not j ust a touching of the line. Price is expected to have contact with the line, but an actual break where price extends beyond it is another story. This is particu larly true if price not only breaks the l i ne, but price bars actually close beyond it. But in Channel Surfing we use two l ines, not just one. So what if price exceeds the opposite line? The answer again is to exit. Even though it may look like the market is accelerating in your favor, when this line is broken it usually develops into a reversal. So despite the apparent good fortune, an exit is still called for. Notice Figure 1-4 and what happens. Odds are that by exiting when a channel line is exceeded you are locking in the highest amount of profit. This is particularly true when an outside l ine is broken because an accelerated move usually ends in a spike before reversing direction. This phenomenon occurs because price hits a critical level and the market over-extends itself. For many unskil led traders this is a temptation they can't resist, a move that appears to be rocketing out of control. Only they are in for a surprise because a rocket out of control usually comes crashing down to the ground. By over-extending itself a market has in essence doomed itself to col lapse.

6

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Since we are using two channel lines that require an exit if broken, then two stop orders would be needed instead of just the usually one stop limit. Additional ly, should either exit order be activated, the remaining order would then need to be cancel led at the same time. Such requirements in your orders can be placed with a broker, but might be diffic ult with some on-line order systems. But aside from these additional requirements, the method is relatively simply to apply. Stop l imit orders are placed just outside, but close to the channel l ines. They cannot be equal to them because the market is expected to actually reach them and you would be forced out of the market needlessly. I f you are trading daily charts and are able to watch the markets during the day, then do not exit immediately when an outside channel line is broken. The reason is that a break of an outside channel l ine often leads to a price spike and a market will tend to move some distance before actually reversing direction. So sometimes it works to your advantage to wait a little longer while it extends as far as it will go before exiting your position and thereby capture more profit. Simply establ ish a new channel line at the accelerated rate and fol low price until this new and tighter channel line is broken. Whether you diligently watch the markets through the day, set a stop based on a recent high or low, adjust your stop at different intervals as the day progresses, or simply have an alert that notifies you when price exceeds a parameter, the idea is to take advantage of the continued move 7

Michael 1. Parsons

fol lowing a channel break until the trend falters. But even if you take the easy way out and place a stop j ust outside the two channel l ines, the key is to keep oneself protected from any undue risk. Just make sure your broker u nderstands that if one order is fi l led that in turn, the other is canceled or you will end up entering a market unexpectedly. There are times when "flipping" your position may be something you would want to do, but usually this is inadvisable. From an emotionally standpoint, exiting out of a market when it appears to be rocketing in your favor is a l ittle hard to accept. After all, the market is accelerating and most traders would think that this is very positive, not something negative. So why would you want to exit at this point? Won't you miss a lot of profit? There are times when you will miss a profit, but look at this realistically; what usually happens when price exceeds the outside channel? Usually it turns around and reverses direction. I f you tried to hold onto your position in the hope that it will continue accelerating, then you will most likely lose a portion of that profit. The loss will frequently exceed any profit you might have gotten by chasing after the market. So unless you are able to closely monitor the move as it is developing, it is best to leave it alone and gracefu l ly bow out. There is an exception to this rule that we will cover much later, but for now the rule is: Exit whenever a channel line is broken, plain and simple. A word of caution is in order here. When a strong trending market exceeds the outside channel it is a sign for exiting your position, not reversing it. I f the market should continue and gap the result could b e a substantial loss. Discretion is the better part of valor here. When a trend initially begins and the first line of support or resistance establishes itself there will be a question as to where to draw an outside channel line, which is used to determine the limit of how far the market is expected to travel. As this point, simply create a line that is at the same angle as your first channel line and place this on the solitary high or low that currently exists on the opposing side. I f you have a charting program that allows it, just duplicate the l ine and move it into place. As a trend develops, channel l ines tend to run parallel to one another and so either l ine can be used to as a gauge for the other. This enables you to establish the channel parameters very quickly and later on you can adjust it as necessary to the actual market when the trend becomes fully 8

Channel Surfing

established. Often there will be a slight variation, but as a rule they will generally be very close in angle to one another, if not exactly the same. The exception is ifthere is an imbalance of power, which will be discussed in a later chapter. In Figure 1 -5, the channel line created by the supporting trend line is dupl icated and then moved with the same exact angle to new high. This completes the channel and provides a starting point to work with. As other highs are established an adjustment of the channel line can be made accordingly.

Resulting i n an exit near the top

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Because this is only an estimated and temporary channel line rather than an actual one, there will be a need to allow some leeway as price approaches it. Price may either fai l to reach it or actually exceed it by a small amount. In either case, price should draw close to the estimated l ine. If not, then it could indicate a problem with any trend development. Additionally, while the line may be broken there should be no substantial move beyond it and any break should only be short-term. Any excessive break or delay in reversing would indicate that your parameters are off. Fortunately, you usually do not have to wait long before you know exactly where a market permanently sets the outside line. From a trading standpoint, the advantage of having an estimated channel l ine is that you know approximately how far price should move. When price backs away after reaching this l ine it wi ll not come as a surprise and create a panic. But there are other reasons for using an estimated channel l ine. 9

Michael J. Parsons

I f price fails to reach this level it would be an early sign that the trend is too weak, giving you an opportunity to exit before it falls back into a losing position. Additionally it can help you to avoid excessive draw down and open up the opportunity to profit twice, taking advantage of multiple moves covering the same territory. I f the distance between the two channel lines is great enough, then it may be more profitable to exit near the opposing channel line (even if it is an estimated one) and reenter when price comes back to your original channel l ine. Because Channel Surfing is so flexible, you can adapt it to all markets, time frames, and market conditions. Figure 1-6 demonstrates how Channel Surfing can be adjusted for a market that is accelerating. This is an important aspect of Channel Surfing because it allows you to always be one step ahead of the market.

Inside c:hannel lines narrow as a market accelerates, tightening your stops and protect your profits Clta.rt

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Initially, a trend can develop a wide channel that narrows down as it accelerates. This acceleration will draw price away from the inside line, diminishing the value of that l ine. This in turn will require an adjustment of the inside line to match the new parameters, even ifprice shows no signs of altering the outside line. An adjustment is made by drawing a new line to replace the outdated one. So as a market narrows, you in turn narrow down your channel line to match it and repeat this as often as necessary. Because trends have a habit of repeating this process several times before the trend actually ends, you frequently end up with a fan l ike pattern. The adjustment of a channel l ine is a one-way affair that continually tightens yoUl stops as the market accelerates. Each new fan line becomes the only 10

Channel Surfing

inside channel line you are concerned with because as soon as the tightest angle is violated, you exit. Handling market acceleration this way allows you to closely monitor your trading and protect your profits. To summarize what we have covered so far; two l ines are drawn to enclose price activity and when price violates either of these l ines you exit your trade. In market acceleration, draw additional new channel lines that form a fan pattern and exit when the tightest of these lines is violated. These rules for exiting will help you to trade more successfully. But for these rules to be of any value, we sti l l need a way to enter a market in the first place. So this is the next area that we will consider.

Entries using channels

Because a wide variety of market conditions can arise, there is in turn a wide variation of entries that can be chosen. The approach you take will depend to a large degree on your risk tolerance. So one determining factor is how aggressive or conservative of a trader you happen to be. Aggressive trading would be viewed as trading with greater risk in the hope of more robust profits, whi le conservative trading would be viewed as exposing yourself to much less risk, but in turn, accepting lower profits. Despite the impl ications, don't automatically assume that aggressive trading is always more profitable or that conservative trading always has less risk. The approach one takes should be based on the conditions of the market that is he or she is trading just as much as one's own trading style and risk tolerance. So the first step is to evaluate whether or not the risk is acceptable to you. This leads to an important question that needs to be answered before entering into any trade; what is the potential return as compared to the risk? This is known as the risk/reward ratio and is a simple mathematical calculation where you divide the potential reward by the potential risk. Ideal ly, you would want a ratio of four to one. In other words, a trade should have a potential profit that is four times greater than the risk that is being taken. Now at this juncture you may be asking, how am I supposed to know what the potential profit will be? Don't worry; you don't have to be a psychic here. We are not talking about predicting the future, just estimating the potential move.

11

Michael 1. Parsons

There are two factors to determine here. First, you are determining where you would exit or place your stop. The difference between this figure and your entry is the risk of your trade. Second, you are determining the likely move of the market and the difference between this and your entry provide your potential reward. This last figure is based on a market's previous action, any channels that develop, and the current trend. Support and resistance levels and recent swings provide a gauge of previous market activity. A larger channel than you are currently trading provides a gauge of possible price movement and this will be covered in more detail later. Additionally, channels provide key information about potential trends and what can be expected. For example, an up trend that has an average move of ten points each day and today happens to have an expected range from 100 to 110. If we are able to enter below 102 and thereby only risk two points while having the remaining potential of an 8 point move, then you would have met the criteria of an acceptable risk/reward ratio. Why would determining a risk/reward ratio be critical? There are two important reasons why, money management and controlling the emotional aspects of trading. These two also happen to be top of the list for destroying trading success. For example, often a trader will attempt to jump into a market when it appears to be building momentum and speed. But commonly this is exactly where a trend will come to an end and reverse direction. But because the trader entered so far beyond any stop that he will set, he has to allow a greater amount of risk and when wrong, accept a much greater loss. Even ifthe market goes your way you can still lose money if the risk/reward isn't reasonable. Slippage alone can eat away at your profit. Imagine the frustration you would have if you tried to buy at 1000 and actually get filled at 1002 and then turned around to sell at 1003 only to be filled at 1001.5. You may have been right about the market and what it would do, but you still lost money because of slippage. Breaking even on a trade is still a loss because you have to pay your broker. Remember that you are trading to make yourself rich, not your broker. Determining your risk/reward ratio helps to put the money in your pocket rather than someone else. The first approach to determining the risk/reward ratio is to simply calculate the trend average and find an entry that is on the favorable side of the trend. What this means is that for you to enter on a four to one ratio you would need to enter within the best quarter of that range. Subtract the low from the high of a channel to determine a trend average and then divide this number by four. Add to or subtract from your inside channel 12

Channel Surfing

line and you know the ideal zone to enter. Ideal is not always practical and there will be times when a trend will not cooperate with this ratio of entry, such as during times of a trend acceleration. In such cases you may have to accept a greater risk, perhaps attempting to enter when you have a two to one ratio. Even though this may be required from time to time, most trends will work with a four to one ratio and an adjustment will not be necessary. Don't allow a trend that is simply uncooperative for a few days allow you to fal l into the bad habit of chasing a market. I n any event and regardless of the trade situation, you should always have a greater potential reward than any risk. If you have an equal risk/reward ratio then it is no better than just flipping a coin. Once you have an acceptable risk/reward ratio, the next step is to enter. There are five specific entries that we will be focusing on in this chapter. There is an aggressive and conservative entry, each with its own specific rules. Additionally, there is an inside entry that borrows from both of these entries. Finally, there arc two other entries called the rebound entry (sometimes referred as the "kiss entry" for short) and the trend entry, which is used for entering after a trend has been established. Initial ly, the focus should be on the conservative entry and the last two entries (kiss and trend entries) because they provide the least amount of risk. So these three entries should be learned first, even though two are actual ly l isted last. In the fol lowing chapter some additional entries will be expanded on that are designed to adapt to breakout situations that frequently arise.

Conservative Entry

The rule for a conservative entry is as follows: Enter when an inside channel l ine is broken and price bars close beyond that line. Waiting for price to close beyond a channel l ine ensures that a break isn't just a rogue spike. Further, it usually doesn't hurt to wait for multiple closes either. A bar close is simply a term that defines where price settled in a given time period. So the issue here is not whether or not price extended into an area, but if it stayed there until the next time period began. Whi le there is a risk of a market rocketing off and leaving you behind as you wait for the confirmation of a bar close, odds are that it won't. In fact, a market will usually pull back toward the prior channel l ine before 13

Michael 1. Parsons

continuing with a new trend. I n the early stages of trend formation there is a strong possibility that a market will give you a false signal. I f this were the case, a premature entry would put you on the wrong side of the market. So this is a good low-risk rule of entry. To illustrate, if you had been in a downtrend and the inside channel line (the one acting as resistance) was broken by price fol lowed by price bars closing beyond that line you would then buy or enter long. In the opposite scenario of an up trend you would then go short after the inside channel line were broken and price bars closed beyond the line. If the market had been in a trading range or sideways pattern and both your channel l ines are horizontal then you would enter when either of these l ines is broken and price closes beyond that line. Figure 1-7 provides an example of a conservative entry.

Enter on the

Crude

all

Ckart

The previous inside channel l i ne now becomes your initially stop. So the rule then would be that if price exceeds an inside channel line and then returns back within the prior channel, then your trade is a bust and you need to exit. A prior channel usual ly works wel l as a temporary stop, but there is a problem that can sometimes arise when using this method. The prior channel line is al ready headed in the opposite direction of your trade and so the stop limit wil l natura l ly increase with time, increasing risk right along with it. Obviously then, an additional limit on your trade is needed. If a new channel has

14

Channel Surfing

al ready begun to form in the direction of your trade, even if it is only partially formed, you can use this to l i m it the risk. However, if there were no clear indication of where to place a stop then a temporary substitute would be necessary. This can be a prior low or a certain limit based on bar movement, such as a maximum of three bars against your trade. For example, if you had entered long and each succeeding bar crept lower, then when a third bar made an additional low you would then exit. Most brief pul lbacks will be three bars or less. A maximum bar limit is comparable to another version ofa temporary stop, the time limit. As mentioned earlier, if price lingers excessively without reversing direction it can be an indication of a consolidation pattern rather than a reversal. Sometimes when this happens it is simply better to get out of a trade when it is convenient. Later, if it does start to go your way you can look to enter again.

Aggressive Entry

The rule for an aggressive entry is as fol lows: Enter when the outside channel line is broken and the developing secondary channel breaks. Remember when I said earlier that a spike that extends beyond the outside channel will often signal a reversal? An aggressive entry takes advantage of this. In this case you are not waiting for any close, but for a spike beyond the outside channel l ine to lose momentum and reverse. This approach has much higher risks and is not for the faint of heart, but if done properly can result in profiting l iterally from one end of a move to the other. There are times when this trade should never be attempted, such as when the market breaks a major high or low or when a report is fueling the move. A market should have already demonstrated that it is a strong candidate for this type of entry even before considering it. If a market is prone to wide swings and sharp reversals then it is worth considering, but if it instead tends to be a slow moving market or one that has had a strong trend that just won't quit then it is inadvisable to attempt this entry. Here is how it works; as a market accelerates it w i l l develop a series of inside channel lines that fan the market tighter and tighter. Earl ier we discussed this phenomenon and used it to signal an exit for locking in higher profits. The difference here is that we are now using it to signal 15

A1ichae/ J Parsons

an entry in the opposite direction of the prevailing trend. To do th is requires that a trading position be very closely monitored, but because we have a break in the larger outside channel there is already a strong indication that a reversal can be expected, even if we initially do not know exactly when this will take place. It is a way of day trading a market even if you normally do not day trade or an aggressive way to extract extra profits if you do. This doesn't mean that you have to suddenly drop everything that you are doing in order to watch the markets. You are simply l ooking for an indication that the market has reversed off the new high or low. Periodically checking a market, having an alert sent to you, placing an order to enter if the market moves off a new high or low by a certain amount, or half a dozen other methods can have you in the market where you need to be. Figure 1 - 8 illustrates how this is done.

When the outside channel line (Line "A'� breaks. enter as the accelerated secondary channel line (Line "B'� breaks

CIw1

.rMetaSiock

A word of caution, if you arbitrarily use this entry you wil l end up being fooled by false signals and take frequent losses. So there are a few qualifying factors to look for. First, the channel line should have been part of a solid trend that had previously held back numerous price bars. You need to have a trend that would naturally elicit a strong reaction when it is broken, so we are not talking about a newly formed trend here. Second, the characteristic spike that shows up as the outside channel line is broken should be an excessively long bar compared to the normal pace of the market. There should be no question that this bar broke the channel 16

Channel Surfing

because it should stand out like a sore thumb. It should also show clear signs of reversing off its extreme high or low. The bar must indicate that it wants to retrace the entire move made by this spike. So you want to see some type of smaller reversal develop that indicates the extreme move is over. In any event, be cautious of any prior highs or lows set earlier by a market. I f this bar breaks a major high or low it can have a tendency to continue the move rather than reverse off of it. So never attempt this at major resistance or support zones. Third, price should reverse immediately off of this bar. This entry should have no delay and each succeeding bar should exhibit a clear change in direction. Aside from the possibility of a spike that is composed of two bars rather than one, no other bar should be equal to, much less exceed it. Any questionable action on the part of price should have you exiting in post haste. Because it requires the abi lity to recognize a number of factors, beginners should avoid this entry altogether. It should only be attempted by experienced traders who understand the subtleties of market action. Normally you should avoid high-risk trades, but if done right th is particular entry can offer some powerful returns.

Inside Entry

An inside entry takes something from both of the previous entries. Like the conservative approach, the entry is signaled with the break of the inside channel line. But like the aggressive approach, you are entering as soon as the break occurs rather than waiting for price bars to close beyond that line. The rule for an inside entry is as fol lows: Enter as soon as an inside channel line is broken. So as soon as the inside channel line is broken you enter in the direction of the break. I sometimes refer to this as a passively aggressive entry, which fits very well but is a term too lengthy to use often. Figure 1-9 shows how the entry is signaled.

17

A{ichae/J. Parsons

at the break of the inside line without waitin g for price to close beyond it

In my own personal trading I tend to favor this approach, but it does require you to be very alert of any sign of fai lure. Just as it is true with the aggressive approach, an inside entry can frequently lead to false signals if you arbitrarily use it. Many ofthe qualifying factors to look for are similar to the aggressive approach, but with a few minor differences. You still want to see that the channel l ine was part of a solid trend and it certainly doesn't hurt to see a spike of the outside channel either. But a spike is not necessary to actually take this trade. However, it does provide an added basis for confidence. Either way, this entry stil l requires you to be nimble and exit at the first sign of trouble. The difference between this entry and the other two has to do with how the market may develop fol lowing the signal . A spike should reverse very quickly, but a break of the inside channel line may take time to develop. Price should fol low through within a reasonable amount of time, but remember that it often requires a l ittle time to build a base to launch from. So the issue is not whether price l ingers, but if it lingers excessively. If what you thought was a reversal turns out to be just a trading range (which can be a waste of time to trade) or worse, a pause in the market that leads to a continuation of the trend, then an exit is cal led for. But obviously, if you jump ship too early you could miss out on a boatload of profits. So anything that happens after the break must be weighed as it develops. What then is a reasonable amount of time? This is a judgment call based on market conditions and how a particular market normal ly behaves, so 18

Channel Surfing

it helps to be wel l acquainted with the characteristics of the market you are trading. But there are two characteristics that may develop that will be important signs. The first is if a market returns to the same high and low price more than two times. In other words, you should see succeeding highs or lows, not a return to the same price level repeatedly even if it isn't the highest high or lowest low. Failure to make progress implies a trading range. The second is if price returns to the actual previous high or low that the market reversed off of in the first place. Neither of these signs is encouraging. When a trade starts to become questionable it is often best to look for a convenient exit. Entries always have risk associated with them and that includes these three. Even the conservative entry is not always low risk, but these entries are designed to get you into a market early enough to benefit ful ly from a new trend. However, a trend can stil l fal l apart and drop into a trading range or revert to its previous direction. Therefore, you need to always determine what your exit will be BEFORE you enter any market. This point is extremely important. If you trade like a cowboy who is shooting from the hip, then you are likely to be gunned down. Know what your escape route is before you are caught in the crossfire. Entries are just one aspect of the trading equation. When market conditions make these entries too risky, then a more conservative approach is needed. The next two methods of entry provide this and are the two that I recommend that you start with, adding the rest later on as your experience grows. So in essence, I have saved the best for last. They are the rebound entry and the trend entry.

Rebound Entry

The rule for a rebound entry is as fol lows: Enter at the break of the secondary channel that rebounds toward the previous inside channel line, as long as it does not exceed the prior high or low. This initially sounds a l ittle confusing, but basically what the rule is saying is that you are waiting for a break of an inside channel that is fol lowed by the development of a smaller channel that rebounds back toward this previous inside channel. As long as price does not exceed the prior channel high or low, enter when this smaller secondary channel breaks.

19

Michael J. Parsons

The theory behind this entry is based on the tendency of price to return to kiss the previous channel good-bye. Most of the time price will never actually reach a previous channel l ine, but it will often make a great effort to do so. As a result, a smaller channel will develop that will angle toward the previous trend. The outside line of this smaller channel will often be a l ittle hazy, but the inside line (which is the line we are most concerned with) will usually be quite easy to define with a simple trend line. When this smaller channel l ine is broken you then enter in the direction of the break or opposite of the previous trend. Figures 1-10 and 1 - 1 1 illustrate tbis entry.

�Secondary Channel that rebounds back toward the original channel

Original channel CIw1

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Enter at the break of � 'h'"" "

I

Secondary Channel rebounds back toward the original channel

Ford

20

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Channel Surfing

A word of caution when using this entry; ifprice in the secondary channel exceeds the previous high or low established by the prior trend, then the risk is dramatical ly increased and the trade should be avoided. At times price will exceed this prior level and the trade stil l goes on to be successful, but the odds in favor of this are greatly reduced. Additionally, if a market goes into a trading range it is more likely to continue the prior trend. In either of these cases it is best to look for a point to exit. If the trade unfolds the way as it is suppose to, then you have reason for additional confidence in the trade. First, you already have a break in the original channel, indicating a trend change. Second, you also have the break of the additional channel , giving more strength and weight to the trade. But there is an added bonus here. Often a smal ler secondary channel will set up the second point from which an inside channel l ine for the entire new trend will be drawn off of. So entering at the break of this channel will usually be very close to an optimal entry. So this particular entry offers one of the best approaches to entering a new trend. While there is stil l no guarantee that the trade will be successful, this entry offers some extra bonuses that put more ofthe odds in your favor which is what trading is all about. Of all the entries that we have discussed so far, this is the most important one to learn. This is the preferred entry when first starting out and the one that I encourage you to use the most. The prior entries depend on the ski l l that you develop and are used primarily with markets that frequently swing. The negative aspect of this trade is that you will miss a few trades that fai l to return to kiss the channel good­ bye. If this should happen, then you need an alternative entry. If you miss your queue on any of the previous entries and a new trend has al ready establ ished itself, another approach will be needed that al lows you to enter a trend in progress. Additional ly, it is not uncommon to find long established trends that almost a guarantee a profit if you just enter. Whether you are dealing with long established trends or short-term swings, it is always important to enter when there is a low amount of risk. Even long-term trends come to an end eventual ly. A lthough the trend entry sti l l has risk associated with it, i t i s perhaps the most conservative and safest entry of the group.

21

Michael J. Parsons

Trend Entry

The rule for a trend entry is as fol lows: Enter an established trend within one-third nearest to an inside channel l ine. What this means is that once the channel lines are established, the average range is then determined. Entry is then set at a price level that is one-third or less than that range and nearest to the i nside channel line. If a market is accelerating at a rapid pace, this ratio wil l tend to be too conservative. In such a case an alternative would be to use a one-half ratio, entering whi le in the better half. The actual calculations will be covered in more detail later, but for now simply focus on mentally gauging this ratio by visualizing the channel split into thirds and in halves. You don't have to be perfect, just close. Despite any apparent strength of a trend, you can never be sure when it will stop and reverse. Because of this possibil ity we always want to limit our risk and look to enter when price is closest to our stop. Since stops are placed just beyond an inside channel line, the closer we enter to this line the less risk we take on. It requires patience to wait for a market to come to you, but the results are much better than chasing after it. There is no way to avoid losses all together when trading, but there are ways to keep losses from putting you on the road to the poor house. So keeping losses to a minimum is a priority. A football team can have a great offense and rack up score after score, but if the defense can't stop the other team from scoring more points then they will sti l l lose the game. So the more you l im it what the market is able to take from you, the greater the odds you will come out the winner. At times this rule of waiting for the market to trade on your terms will mean that you will m iss out on some very rewarding moves, but a market that suddenly rockets w i l l also usually burn out very quickly. Figure 1 - 1 2 shows how a trend entry is made.

22

Channel Surfing ".)1

Enter when price is closer to the inside channel line of an established trend

Channel

Avoid entering when price is near this channel line Manugistics

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G• •• " H •• o. " " " .0 1@ 1$ 11 ,. TS " ., " " 1' • •9 •• " ,. ,; .< 03 " " •• I• . ,' " .. .. " n

Trend entries are an excel lent way to start out when first learning to trade. It follows the wel l known rule to trade with the trend. You are not attempting to buy a bottom or sell a top, but instead taking advantage of a prevailing move. So this entry method is one that you should learn well because it will serve you well . The negative aspect of this entry is that markets frequently swing up and down rather than move in a steady trend. So using just this method will mean that there are fewer trades to take. It also means that you will miss a good portion of any trend, at least the initial portion. But the trade-off will be that more of your trades will end up being successful. It will also go a long way to build up your confidence and skill. As you skills improve you can add the other methods of entry that fit your style of trading. Just bear in mind that with any entry you use, the key is to always enter when you have the least amount of risk. So to summarize, the entries are as fol lows: For a conservative entry, enter when an inside channel l ine is broken and price closes beyond that l ine. 2. For an aggressive entry, enter when the outside channel l ine is broken. 3. For an inside entry, enter as soon as your inside channel line is broken. 4. For a rebound entry, enter after the break of a secondary channel that returns to kiss the previous channel good-bye. 5. For a trend entry, enter an established trend closest to the inside channel line. 1.

23

A1ichael J Parsons

The fol lowing chart examples should help to strengthen your understanding of these entries. As you review them, look for ways that you can apply these principles to current markets.

Notiee how the market dropped after breaking the inside ehannel line

Chart

priee breaks the outside ehannel line----... An even better exit is signaled when

Exiting with this signal loeks in even more profit

24

Channel Surfing

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Exit also signaled here

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Michael J. Parsons

Conse'rvative

Trend Entry

Long from here Gold

Despite my initial recommendations, eventually you will be faced with the question as to which entries are best for you. The answer would depend on your own trading style and the amount of risk you are will ing to accept. Only you can make this decision. You may decide to use all of them or favor just one or two. There is no right or wrong answer here. But start by focusing on the two recommended methods of entries and you can expand later as you become more proficient in using Channel Surfing. The rebound entry and the trend entry tend to be the most conservative and least l i kely to cause confusion. The other entry methods can be added later as you become more comfortable with the mechanics of how they develop. As the expression goes, "the devil is in the details" and so it is true in trading. There will be many times when you will come across similar trading set ups where one will have success written all over it while the other will reek of fai lure. An inexperienced trader will look at both and see no difference between the two. An experienced trader will recognize right away that there is a distinct difference between them even ifhe can't quite put his fi nger on what that difference is. The answer will be in the subtleties that only experience teaches. So take the time needed to gain experience in using the entries discussed here and it will increase your odds of success. One example where the subtleties will make a substantial difference is in how you interpret a channel. Remember, the ideal channel will have two lines that run in parallel to one another, both set at the same angle. 26

Channel Surfing

But there are times when it is necessary to fan a channel, such as when a market accelerates. The first and foremost use of fanning is for exiting. It can be used for entering, but caution needs to be considered when doing so. You see, there is stil l likely to be an existing paral lel channel l ine even if you cannot detect it yet. An invisible channel l ine can occur with either side of a channel, but when it is an inside line it will often become a problem just when the market seemed like it had already confirmed a reversal. Often, price will just bounce off this hidden l ine and resume the prior trend. To "see" where this channel line is hiding is a simple process of duplicating the outside channel line and placing it on the inside channel point that is extended the furthest out of range. This point is usually easy to identify because it would have been the main culprit in "distorting" the inside channel l ine originally. Figure 1 - 1 8 shows an example of a hidden channel l ine.

.

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Channel Surfing sum mary

Before I cover any new ground on this subject, it would be appropriate to review some key points already discussed. 1.

Channel Surfing involves the drawing of two trend l ines referred to as channel l ines to encompass price movement either in a trend or in a sideways pattern. 27

Michael 1. Parsons

2.

A channel l ine is drawn off a series of highs or a series of lows. 3. The channel l ine to the right is referred to as an inside channel l ine and the channel l ine to the left is referred to as the outside channel l ine 4. Channel l ines behave as a fence and direct price in a particular direction whether this is up, down, or in the case of a trading range, sideways. 5. I f either channel l i ne is broken, than open positions would be closed. 6. There are five methods ofentry and they include; conservative, aggressive, inside, rebound, and trend.

As a reminder, a key component of Channel Surfing is exiting whenever either channel line is broken. Any open position would be closed or exited from even if it happens to be the outside channel l ine that was exceeded. This exit rule would apply to all styles of trading no matter how aggressive or conservative the approach may be. Exits can be set up by placing orders just outside the existing channel lines so that an open position would be closed if either is reached. When one order is fil led then the remaining order would then be canceled. In the case of an aggressive trader, an entry can be made when an outside channel l ine is broken as long as the situation implies that a reversal is imminent and certain requirements are met first. A passively aggressive trader would enter upon the break of the inside channel line and this is known as an inside entry. I n contrast, a conservative trader would wait until price bars actually close beyond the inside channel line before entering. A n even more conservative method is the rebound entry which is signaled by the break of a smaller secondary channel. Finally, a trend entry would be made after a trend has established itself and within one­ third of the trend range, closest to the inside channel. Before continuing, it would be good to clarify a few aspects related to developing your own style of trading. Just as a surfer can choose from among a variety of surfboards, beaches and waves, you too have a variety of choices when it comes to the markets and time frames that can be traded. The choice you make can make the difference between a profitable trade and a losing one despite the strength of any trading method you possess. In real life no one is going to buy an Enron when it is clear it's headed for bankruptcy, so don't trade a dead horse. Slippage will create problems if you 28

Channel Surfing

are trading shrimp so avoid shrimp sized markets. There is no money to be made if a stock has stayed at the same exact price for twenty years and looks to remain that way for the next twenty, so avoid sticks in the mud. Once you have a decided on a market that suits you, the next choice will be the time frame that is best for you to trade. This is not a simple decision. Too large of a time frame and the draw down will be murder. If you do not have the capital to handle larger time frames, then just a couple of bad trades wiII deplete your account in a very short period of ti me. Too small of a time frame and you will never see a profit. After all, how can you trade intra-day channels if you only check charts at the end of the day? Or how can you make any money trading minute by minute if the market barely moves at that level? Choose the wrong time frame and your trading will cause you undue frustration and losses. Your choice of a time frame is not based solely on your convenience. Just because you may l ike to trade five minute charts doesn't mean that you should. There is a balance that will be based on what a market allows and what fits your comfort level. For example, many new traders first start out trading daily charts. This can be an excellent time frame to start with unless the market gaps excessively. During times of high volatility, a market may be prone to very fast and wide swings. Trading these swings may require much larger channels that bring with them much greater risk. A single loss at this extreme size would be a huge blow to most small traders. But if you use too small of a channel then it can nickel and dime you to death. A proper channel will al low enough breathing room to allow a market to move while keeping the draw down tolerable. The benefit of Channel Surfing is that it is fle xible with many choices. If you cannot tolerate larger draw downs then it wil l just mean you will have to monitor the market more closely using smaller channels. If you have a budget that allows more room for draw down then by using larger channels you have the opportunity for greater profit with less effort. It comes down to this; your choice isn't about choosing between the largest time frame and the smallest that is to your l iking, but a compromise between the two that fits your trading style, risk tolerance, and patience wh ile providing clearly defined channels to trade off of. It is more the size of the channel itself rather than a specific time frame.

29

Michael 1. Parsons

In a later chapter we will discuss the use of multiple time frames so that you can get the best of both worlds. There is a great deal of value in using multiple time frames, but for now it is important to be able to identify which channel and time frame is right for you to trade. Figure 1 - 1 9 shows how Channel Surfing can be implemented different situations that can develop.

ill

the

What you have seen applied here with this daily chart will work in whatever time frame you are using. If you were trading intra-day, then you would use the same exact rules and techniques whether you were looking at a 30-minute chart or a 5-minute chart. The rules do not change. Trade the same way you have learned here and keep the rules simple and they will serve you well. The rest of this book will be devoted to expanding these basic concepts with advanced techniques that will drastically improve the success of this method. For this reason I would suggest that you hold off trading until you have had a chance to read what these techniques are. A lthough it is true that even without the rest of the book you would have a measure of success, the difference can be as vast as a beginning surfer trying to compete with a professional. There is no dispute that the professional will come out as the winner. Even so, what you have learned so far will serve you better than most methods that are currently used today to trade the markets and this will give you a decisive edge. While they are struggling to keep their heads above water, you will be surfing above them all and making money, and that is always fun. But then again, surfing always is. 30

Chapter TwQ

Breaking Waves To get the most from a wave a surfer attempts to catch it just as it begins to break. The area where waves start to break is known as the impact zone and this is where you will see surfers' congregate, waiting for their turn to catch a wave. Channel Surfing works in a similar way because most ofthe entries are based on the break of a channel line. But a breaking wave can at times be hard to predict. While we may already have several choices for entering a market, all of them are based on a clear and distinct channel that is either fully or partially developed. Unfortunately, some markets can be very uncooperative about revealing a channels form, making it very difficult to pinpoint a low risk entry. So a modified entry is necessary in order to get around this problem. One case in point involves the early stages of a trend before any channel is well defined. Price may be breaking higher or lower and giving clear indications that there is a valid trend in there somewhere, but you can't seem to put your finger on any specific point of entry until after it has jumped to a high-risk area. A market that repeatedly gaps and then pauses is a prime example and can be very tempting to trade because the jumps in price tend to be very quick and large moves. The problem is that every time it does pause it just lingers there without any indication of the direction the next break will be in. This can leave you very nervous about attempting any trade. So the profit potential is there, but you just don't have the confidence to trade it. Because a market like this tends to jump so radically, a low risk entry is essential in case you are wrong about the direction of the market. What this all boils down to is that you need a simple way of determining 31

Michael 1. Parsons

which direction the market is leaning toward before the move jumps into high gear. Without some sort of early entry method you can easily find that the profit opportunity is all over before you even have a chance to enter. The way around this is through a few modified rules for Channel Surfing that focuses on specific situations related to breakouts. A breakout entry is designed to take advantage of a modified channel signal. It takes a little more effort to construct, but is much easier and effective to enter when the situation calls for it. Breakout entries are not a new concept. In fact, many trading systems are totally depended upon them. The theory is that once you exceed a certain level then the market should continue in the direction of the break for some time, allowing a person to make a profit. This method has proven itself many times over. It fol lows a very simple and basic law of physics; once an object is set in motion it will continue in motion. Only in this case we are talking about price. To be a true breakout entry price has to breakout ofsomething. It isn't enough to have prices rising or dropping in the normal course of a trend, but rather price had in a sense run into a brick wall and then had to develop enough force to break through. If something has enough force to break through a brick wall it isn't likely to be stopped anytime soon. So the obvious first step to finding a breakout trade is to find the proverbial brick wall. Of course, there are no literal brick walls in the market, but support and resistance levels behave similarly. Support and resistance levels are simply price levels that the market reached but couldn't exceed. In essence, they are horizontal fences that price is likely to bounce off of because it did so in the past. Find a place where price set a new high or low and then fel l away from it and you have one of these fences. The more times that price bounces off support or resistance, the more solid that support or resistance is. It's as if each bounce is another brick that is added to the wall. So ideally you want to look for levels that price had bounced off of several times in the past, because once price does break through and holds it should continue for some while.

Trading range breakouts

An ideal example of this would be a trading range. A trading range locks price within a high and low boundary. Sometimes they can run for 32

Channel Surfing

extended periods of time with price continually bouncing from side to side. But watch out when it final ly breaks out of that range! Take a look at figure 2-1 for an example. 11Q1 1101)

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It is important to emphasize here that a trading range involves multiple hits against the high and low boundaries. One or two do not make for a solid range and in turn, leave any breakout weak at best. The more hits at the high and low ranges, the more reliable the breakout is likely to be. Trading range breakouts tend to be solid trades as long as you allow the market to confirm the breakout. However, caution needs to be exercised because even in this situation you will commonly have false breakouts. False breakouts occur when a market exceeds a level but fails to sustain it. Instead price returns back within the zone prior to the breakout. Fortunately, there are two reliable ways that a market will confirm a breakout. Either one can be used as a basis for entering with confidence. The first confirmation is the close beyond the breakout. For example, if you break to the upside the previous resistance line should now act as support. Rather than falling back below this l ine you should see price bars closing above it. It is preferred that at least two closes occur beyond a breakout line before entering a trade; the breakout bar and a secondary price bar. AdditionaLLy, you should see momentum start to pick up withi n a short period o f time away from the breakout leveL. This entry is similar to the conservative entry that was discussed in the first chapter. Figure 2-2 demonstrates how it works. 33

Michael 1. Parsons

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The secondary confirmation is a panic bar. This occurs when price exceeds the range and the price bar explodes like a rocket and never looks back. Momentum picks up and continues to increase. How far does a bar need to extend before it is considered a panic bar? There is no exact answer to this, but the key to determining this is found in the action of previous bars. Look before the trading range and compare the pace that price set with in the market. A panic bar will often extend twice the length as normal and stand out as significant. A market is also likely to have other examples of panic bars to compare with, such as when a major reversal occurred. Markets tend to be prone to panics so it would be unusual to have just one showing on any chart. The problem that you can have with panic bars is that you can place an order early on just as the move gets started and still not have it filled until it comes to an end, leaving you exposed to higher risk. Fortunately panic buying usually begets panic buying so it is still likely to be a solid trade as long as the market doesn't take a break. Beware of holding a position based on a panic that extends through a weekend or holiday. Breaks in trading will take the steam out of panics and they will lose their momentum. Figure 2-3 shows an example of a panic bar. The goal of confirmation is to provide some sort of indication that a breakout is for real and not a trap. I f a market exceeds a trading range and then returns back into that range, you are not likely to see it break out in the same direction again for a while. In fact, a false breakout often signals that the market will move in the opposite direction. So beware of any time you see a market return back within a prior range. 34

Channel Surfing

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One other factor that adds to a confirmation is an increase in volume or the number of trades. We are talking about a substantial increase, not just a minor one. Greed and panic should be motivating the market during these times, resulting in a flock of traders scampering to get in or out. I f there is no serious increase in the amount of trades, then the market i s not responding positively to the breakout and may fail to sustain it and is in danger of failing. These confirmation techniques can be used for practically any type of breakout trade you are considering. There are a number of patterns where you can readily apply them, such as with triangle and wedge patterns. But some breakout trades will require a more aggressive approach by entering at the break. Of course, these trades will also include more risk, but the pay-off can be more frequent trades and greater rewards. However, it must be understood that the breakout trades that we are about to discuss are not of the same caliper as trading range breakouts. There are usually no multiple hits against support or resistance and you are not likely to see any substanti.al increase in volume when they break. Earlier, we discussed an entry based on the break of a secondary channel called a rebound entry. The signal required a previous break off of a larger channel before a set up was in place. I n effect, the two channels acted as a form of confirmation because of a repeated break. Now we are returning to this same basic concept, but with a twist.

35

Adichael J Parsons

Mini channel breakout

When a market is unclear about a channel parameter you will often have instead smaller channels that develop somewhat like stair steps. Obviously, there is a trend in there somewhere, but it is difficult to put your finger on its limits. By using a similar approach as we did with the rebound entry we stil l have the ability to trade such an obscure trend. The difference here is that rather than based on the break of a larger channel you are simply looking for smaller channels to repeat a break in the same direction. So in a sense this entry is based on what could be referred to as mini-channel breaks. The basic concept fol lows these steps: A market breaks a channel, whether large or small, and then forms a mini-channel. If the mini-channel breaks in the same direction as before and continues the trend direction you then enter at the break. A stop is set just before the mini-channel zone that was used to signal the entry. Figure 2-4 demonstrates the technique.

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This method of entry has a higher risk associated with it as part of the deal, but it does resolve a few scenarios where entering would normally be a real problem. Just remember, you are looking for a secondary break in the same direction, one right after the other. If you have a market that breaks a mini channel in the opposite direction in-between the two then this approach will not work. To be valid you must have a market stepping either up or down, not both ways. 36

Channel Surfing

This entry is particularly valuable when trading a market that frequently gaps. If you day trade, then you know that this is a real problem when starting any trading day. When a market opens with a gap because of overnight trading it frequently attempts to close that gap before doing anything else. But this is in opposition to the established trend. With no activity to really base a channel on you could be left out of a good part of trading while you wait for some parameters to be established. This method allows you to overcome this lack and enter more quickly. Using a mini-channel break to enter a market works with another type of confirmation. Rather than a prior channel break, the next entry simply uses a prior trend to confirm the mini-channel break's validity. Throughout any chart you are likely to see trends that pause from time to time as if they ran out of steam and needed to stop and take a breather. It isn't that the trend has really finished its run, but simply that it needs to regroup before going further. These pauses will often form mini-channels. One of the many examples avai lable is the flag pattern. Flags are short lived and will often exhibit a tendency to drift in the opposite direction of the market trend, thereby creating a mini-channel. Usually this mini­ channel will lead to a continuation of the prior trend. Unfortunately, a trend can also have a dying top where it slowly drifts into a reversal and will exhibit similar characteristics, so it usually best to wait for the market to tip its hand before committing to a trade. This tip or signal to enter is found in the break of the mini-channel. A lthough no prior channel breaks exist that you would normally use as confirmation, the prior trend itself serves the same purpose. The only requirement is that both the prior trend and the mini-channel break be in the same direction. An example can be seen in figure 2-5. It doesn't matter whether we are talking about a channel break or a trend, for a mini-channel break to be valid they must both be in the same direction. If the market was in an up trend j ust prior to the flag and then the flag broke downward, then this would not qualify as a valid signal. It is possible for such a move to qualify under the normal entry rules, but that would then depend on a larger channel and the overall trend. Do not confuse the two methods of entry. Aside from this and the added risk, you will certainly find plenty of opportunity to use mini-channels in your trading. They frequently show up within any market providing some great trading opportunities.

37

Michael 1. Parsons

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Trading false breakouts

In real life, trading a breakout is not always as simple as we would hope. There are a host of reasons why a market may muster enough strength to break through a wall and stil l falter and return to the prior side of that wall . A failure is referred to as a false breakout, a term that is very fitting. Synonyms for the word false include terms such as misleading, deceptive, wrong, fabricated and deceitful. All of them apply well in describing what a false breakout means for a trader. This is why there is a need to look for confirmation on any breakout trade you are considering. Unfortunately, false breakouts are a frequent occurrence and are very effective in trapping traders on the wrong side of a trade. So what do you do if you entered a trade only to discover that it was just a false breakout? The first step is to get out of your trade as soon as possible. As simple as this statement may seem to be, when dealing with breakout trades this is an extremely important point to understand. False breakouts have a nasty habit of moving in the opposite direction and sometimes this turns out to be a considerable move. In other words, if you bought on a breakout to the upside and it turned out to be a false, then price may not only drop back within the pre-breakout zone but continue to fall much lower. If you fai led to exit at the first sign of trouble you could be looking at a substantial loss. 38

Channel Surfing

Despite the prevalence of false breakouts, there are times when a market will seem to fail to follow through and drift back into the previous zone, only to reestablish a channel that carries it back in the direction of the original breakout and beyond. So a return to a prior zone does not guarantee that your trade has gone wrong. A saving grace will often be the channel that forms just before a breakout occurs and this can be used to judge the progress of any breakout. If this channel holds despite returning within the prior zone then there is a possibility of a successful trade. If it fails then the odds of success dramatically drop with it and you need to exit. An example of a channel that brings a false breakout back to life can be seen in fig ure 2-6. - . 11 .

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So a fai lure can still become a success as long as a channel manages to hold. Even if it did turn out to be a bad trade, you may still be able to take advantage of the signal in another way. A fai lure has the tendency to carry a market a considerable distance in the opposite direction, so reversing your position can turn out to be a very profitable trade. This is particularly true when it involved a break of a major brick wall of support or resistance and failed to follow through. Remember, if it took a considerable amount offorce to break through it once, it takes a similar force to break through it a second time. In essence, it is a breakout trade that breaks out again, only this time in the opposite direction. Don't take this move lightly because the market will not. It is the nature of the market to implode on itself when there is a failure and this tendency offers one more opportunity for profit from a breakout or in this case, a failed breakout. 39

Michael 1. Parsons

False breakouts have an added force hidden within them. It is called limit orders and they can be found sitting at predictable levels within a market, especially just beyond breakouts. Traders who themselves are trying to take advantage of a breakout trade as a market hits new levels will place standing limit orders just beyond the breakout. As I mentioned earlier, breakout trades are nothing new and used quite frequently by other methods of trading. So as price hits these levels a flood of orders is activated. This initially adds strength to the conclusion that a breakout is valid, so often others will jump on board as wel l . But if this demand is not enough to sustain the move then the market quickly returns back into its previous zone. Now all these traders who had their l imit orders activated have a problem, they are sitting on the wrong side of the market and in a loss. So many of them start to scramble to get out of the trade and this pushes the market further away from the original breakout, fueling even more orders. As fear picks up, the market is often pushed beyond any range that was established and panic ensues, driving the market even further away. So if you can correctly identify that a false breakout is occurring early enough then you are in a prime position to make a very nice profit. The key to this trade is to expect certain requirements to be met. Otherwise the move will tend to be very weak. The main requirement boils down to whether the breakout was a substantial one or not. There are two ways a breakout will establish itself as significant before it occurs and if either are present then it would certainly qualify for reversing positions when a failure does happen. Repeated attempts at breaking through a barrier would certainly qualify. This is in essence what happens with a trading range. So a well defined trading range where a fai led breakout occurs is an example of a good candidate. The second way would be when the market set a prior high or low and significant time has passed before attempting to break it again. In this instance, it is the time factor that makes it significant. It took a considerable effort for the market to return to that same level again. I f price now breaks this high or low but still fails to sustain it, the market will likely react by moving in the opposite direction, just as it did before. This second version can seem a little difficult to interpret. The question that invariably arises here is; how much time is considered enough of a time elapse between a prior high/low and the one that breaks it? The answer is simply; enough time to establish that any break is a serious 40

Channel Surfing

accomplishment by the market. This is usually a judgment call based on how the market develops, but it can be based on a more restrictive and defined rule such as a set period of time. For example, you could require that any breakout fai lure be at least twenty days from the prior high or low it exceeds before considering a trade. This way, there are no questions as to whether enough time has passed. Some trading methods use this exact same rule. But this is only a hypothetical rule and what you use should be in line with how a particular market has responded to false breakouts in the past. The important issue is that the high or low stand out so that any break will catch the interest of other traders. It is additional traders that fuel these moves. If it isn't a breakout that stands out in your mind, odds are it will not be outstanding to others who are trading the market. If you see it as significant, odds are that others will too. Figure 2-7 demonstrates how significant this can be.

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Breakout entries have their inherent risks, but utilizing these set ups can also provide a wealth of profitable trading opportunities. At times you may even find yourself dependant on them to make a large portion of your trades. Some markets are best traded using breakout entries while others will tend to slap anyone that tries to trade this way. It will take some perception on your part to know which the market you are trading favors. In any case, it is important to realize that breakout entries are simply an addition to the original Channel Surfing rules and not a replacement. A ny market you are trading still requires you to establish the parameters and risk as best as you can before even considering a trade. It also pays to be 41

Afichael J Parsons

n imble, particularly if any sign of trouble exists. Breakouts tend to move very fast, even if they fail. But on a positive note, breakouts tend to work out well in a large percentage of trades. So don't forget to use this entry as you become more proficient in using Channel Surfing. Just set up in the impact zone and hit those breakers !

42

Chapter Three

Kiss of the Channel Line While the title of this chapter may conjure up thoughts of a romantic interlude while surfing channels, the kiss of the channel line has nothing to do with us personally. The love of its life is price and understanding the choreography between the two elements allows us to exploit the attraction between the two for profit, not love. There is a lesson to be learned here from a movie entitled "Kiss of the Spider Woman". Technically, it was a movie about two prisoners and how one uses a Nazi propaganda movie he once saw about the unlikely love affair between a French chanteuse caught up in the Resistance and the chief of German counter-intelligence for occupied France to manipulate a fellow prisoner into accepting a homosexual relationship that he would otherwise have viewed as repulsive. In the end he succeeds. So the movie is really about the process of weaving a web of emotion around an extreme point of view in order to manipulate a person to accept it, even though he would normally be repelled by such an action. The lesson here is a psychological one, having to do with taking one relationship and using it to manipulate another. So it is true when it comes to learning how to trade. We have to take certain aspects of the relationship between price and channels and weave them together in order to extract a profit. As in this movie, you are in essence playing off the psychological extremes of other traders while they are manipulated into accepting what they would normally be repel led by, taking a loss.

43

Michael 1. Parsons

The point here is that whi le Channel Surfing is a technical trading method, its success is rooted in crowd psychology. It is important that you understand this concept because the market is designed to play on one's emotions and does so in extremes. Emotionally you want to sell when you need to buy and buy when you need to sell . For most, emotion will overrule logic. Our heart can make even the most foolish act look l ike a good idea. Ask anyone who has fallen in love with the wrong person and they will agree. This is why understanding what makes channels tick and how markets really operate is so very important. Otherwise, you we will be caught up in the emotional roller coaster that will have you manipulated into doing what you would never want to do, take a loss. Here lies one of the hardest lessons for traders to learn; despite all that you learn the market will still find ways to have you doing what it wants you to do. It is for this reason that some people wil l never succeed in trading. When the market starts rocketing higher, it screams at you to buy as greed takes hold. The temptation becomes unbearable and you can hardly restrain yourself, but restrain yourself you must because the turn­ around is imminent. Or immediately after you have bought price spikes lower and fear grabs hold of you. Seconds seem to last hours as panic sets in. The market screams at you to sell and you can hardly contain yourself, but contain yourself you must because as soon as you exit you do so at a loss and usual ly just before the market finally moves your way. All the profit that would have been made has passed you by. Can you fight and control these emotions? There is absolutely no avoiding them. You will have to face this battle and only you can conquer them. I f you cannot d o so, then nothing in this book o r any other will help you to trade successfully. Fear and greed will warp your senses into believing you see things that are simply not there. Only by detaching yourself emotionally from your trading will you be able to trade logically and perceive what is really happening. A market is a living organism with a will and personality of its own. Like a wild animal it cannot be trusted. But it can be managed, at least in regard to specific situations. However, even in controlled situations you cannot let your guard down, particularly when you are dealing with a predator that will chew you up and spit you out. Our greatest vulnerability to this beast is our emotions. Many forms of spider venom attack the nervous system, rendering a victim helpless and unable to move. The market's venom also attacks the nervous system, but instead causes erratic and uncontrollable movement. Beware the kiss of the spider. 44

Channel Surfing

Despite this reality, the way a market unfolds with channels and their subsequent dividing lines is a beautiful process to behold. The intricate design of these lines will often literally reflect that of a spider web. But if we have a spider web then we have a spider. For most smal l creatures being caught in a spider's web means a death sentence. For man, the kiss ofthe spider is a painful one, but that has not prevented man from profiting from the use of spider webs as well. For example, primitive people in New Guinea have used spider webs as fishing nets, while others have used spider webs to make clothing and thread. The difference is in who is exploiting the web, the spider or man. In order to exploit the web the user has to understand it. The same is true in regard to the markets. But while a web is designed to remain stable, markets are not. They are ever changing l ike that of an ocean. Yet, even an ocean has a "web" of interconnected I imits that it weaves throughout itself. Understanding how those limits are set will increase your understanding of how a market weaves its own web as well. Despite appearing chaotic, the waves of an ocean are still built upon the laws of physics. Obviously, an ocean is not built in the same manner as you would build a house. A bouse is rigid and unchangeable, an ocean is not. But an ocean is subject to some very specific limitations, making certain actions predictable. A wave will not raise above its shoreline limits, only an additional influence such as a storm or tidal wave can do this. It has to instead settle on a very narrow range of shoreline determined by the tide and wave strength. Additionally, a wave will not break in the direction away from the shoreline. It must always break toward the shore and do so continual ly. These simple limitations enable a surfer to take advantage of an ocean and its waves. Still, a few l imitations are not enough to allow a surfer to surf. A surfer also needs to understand the subtleties of how these limitations work. There are no surfers out on their boards using a slide rule or calculator. They use their experience and knowledge to judge what will unfold. So too, more is needed than just simple rules to trade successfully. One also needs to understand the how and why. Perception is a required ski l l i n this business. Just consider a few o f the rules that we bave covered so far and you will find that in real life applications there are a few situations where they appear confusing and even contradictory. The rules are solid, but you have to apply them to something that is not. Markets are ever changing and require greater perception than any simple entry and exit rules can provide. 45

Michael 1. Parsons

Channel lines provide a means of gauging price, allowing us to perceive what its l imits are. However, channels never dictate to price, price instead dictates to channels. This is the relationship between price and channels. Channels are created by price action, not the other way around. A surfer may expertly surf a wave, but he can never control it. There is nothing he can do to alter when a wave comes in, how it will break, how large it will be or anything else that a wave may possibly do. He is only a rider of that wave and nothing more. Since a channel line is nothing more than a surfboard enabling us to ride a market wave, there is nothing we can do to control price either. Channel lines work because they identify and follow a natural phenomenon of price action, just as a surfer is able to surf a wave because of a natural phenomenon. While it may be beyond our abil ity to control this natural phenomenon, it does tend to reoccur often enough to allow us to take advantage of it. Waves will repeat over and over in a series where one fol lows another even if none are exactly the same. So a surfer knows that if he misses a wave he doesn't have to worry because another will fol low shortly. Market waves will often do something similar and have a series of channels that form one after another, often overlapping each other. They demonstrate in various ways that they are interconnected even though each is a distinct wave. Even within the channels themselves price will swing in a repeating fashion with similar breath, length and angle. Repetition demonstrates that each part is interconnected with that of the whole. Like a web, each strand is connected in such a way that if one is touched it vibrates the entire lot. A pattern is established that will set the pace and personality of all that fol lows.

Changing of the guard

A n example of such interconnected phenomena can be seen in a trend shift. Trend shifts occur when a price trend develops a fault line and shifts a channel, only to resume the trend as if nothing out of the ordinary ever happened. Channel lines will usually switch roles when a trend shift occurs and what was once support suddenly becomes resistance or what was once resistance suddenly becomes support. One can interchange with another and revert back again. The interchange extends further in cases where a channel l ine becomes the launching pad for a new trend as a market changes direction. Price has a habit of kissing its former lover or channel 46

Channel Surfing

good-bye. This habit works to our benefit, allowing us an opportunity to exploit the changing of the guard. There are three primary ways in which a changing of the guard takes place. l . When a trend reverses direction 2 . When the trend continues after pausing 3. Changes in momentum and trend shifts Each of these events will tend to exceed a channel line and normally require us to exit a market. But under these special circumstances it may actually be more appropriate to either stay in a market or even enter. While we have already explored some of these entries, the key here is to understand the actual mechanics behind these changes and the subtleties that make or break a trade.

When a trend reverses direction

Trends reverse direction all the time. It is not a question of "if" a trend will reverse, but when. When a price spike breaks an outside channel line it frequently serves as an early warning that a reversal is imminent. Unfortunately, a spike is not always present during a reversal. On the other hand, a reversal always breaks the inside channel l ine because there is simply no way to avoid it. But just because our inside channel line has been broken doesn't necessarily mean that price is completely done with it. You see, price created this channel line in the first place because it was naturally attracted to a certain l ine of progression. Even though the trend is over, the attraction is not. Frequently you will see price attempt to return to this l ine as if to kiss it goodbye. This doesn't happen all the time, but enough to give you a trading opportunity if you miss the initial channel break. There are also times when it would be helpful to have more confidence that a reversal has actually occurred, particularly if a trend has had a habit of false reverses in the past. Or you may have missed the initial break of the channel line and don't want to risk chasing the market. In either case, price's kiss goodbye may be the solution you have been looking for. Catching this initial pullback at its zenith can provide you with a low risk, high profit opportunity. I f you are wrong you risk only the difference 47

Michael J. Parsons

between your entry and the reversal's extreme price. Figure 3 - 1 shows how good of an entry this can be.

Although price breaks through the channel line. it still tries to return and kiss it good-bye

Chart courtesy ofMetaS1Dck

British Pound

While price doesn't always kiss the channel line goodbye it happens frequent enough to look for it. Failure to do so usually means that the new trend will move very rapidly and far. I f this is the case, then getting i n at the best price doesn't really matter as long as you do get in quickly because you are stil l likely to make money. However, if you hesitate and miss getting in on such a fast-mover, it is best left alone. Quick moves have a habit of springing back and catchi ng any Johnny-corne-lately for a quick loss. I f a market happens to gap away twice from the prior inside channel line, then there is a good chance it will continue. Two gaps in a row tend to show strength in any new trend. I n any event, vigilance is needed because volatile moves tend to swing both ways. Trading fast-movers is as much an art as it is a skill. Because a fast-mover is frequently difficult to judge, our focus is better served on the pullback toward the previous channel line rather than the runaway market. When price attempts to kiss this channel line good-bye, a small trend will form that signals an entry when broken. That is as long as this pullback doesn't exceed the prior high or low that ended the previous trend. The reason that this works is because the prior channel line still acts as an attraction and part of the inherent geometry of the market. When you build a house you butt the end of one wall against another. When bees build a nest, they join one honeycomb cell to another. When you write a letter, you fol low each word in sequence. When multiple parts are joined 48

Channel Surfing

as one, they make the whole stronger. In like manner, price will naturally attempt to connect to itself in some form or fashion. Entering as price draws near to a prior channel line is often an ideal entry because the risk is small and the profit potential high. But this stil l doesn't guarantee a profitable trade. Unfortunately, it is also not uncommon for a market to excessively drift, paralleling a prior channel line for quite some time before actually breaking in the direction of the new trend. This is one of the quandaries of trading that despite breaking a channel, price can still exceed a prior high or low and continue in its prior trend's direction, resulting in a loss. Only after a new trend is clearly established do you know for sure whether an entry was good or bad. Obviously, you want to get in at the very best possible price, which requires an early entry. But you also don't want to take a heavy loss or do the opposite, get too nervous and jump out too soon, missing the trade entirely. So how do you know when a drift is just a minor delay in a new trend or a failed break that threatens a major loss? While it is possible for a market to develop a double top or bottom or even slightly exceed prior highs or lows and still reverse, the odds change dramaticall y when it does. It is better to take a small loss than to risk a large one. Once a market breaks a prior high or low, the move can be extremely fast. The slippage can be very large if you hesitate too long. H is a sickening feeling to have the points rack up against you whi le you desperately try to get out, but are unable to find someone to take the other side of your trade. If there is no indication of a channel that will provide support or resistance in close proximity of the previous high or low, then the high or low has to act as your limit. Multiple attempts at this level or actually exceeding it will require an immediate exit. This possibility emphasizes that the best approach for a beginner is usually to wait until the small channel is actually broken before entering. But entering is often a matter of taking stabs at a market, getting out of the ones that become questionable and sticking with the trades that show signs of paying off. A prior channel line acts as an indicator of what will unfold. Even at the expense of exceeding a prior high or low, this channel line will normally be the limit of price's progression and once it is reached price should show clear signs ofreversing direction. If price reaches this point and fails to reverse quickly, the trade's success quickly fades with it. An important early warning that a reversal may fai l can be seen in the price action immediately fol lowing the break of the prior channel l ine. 49

Michael 1. Parsons

The two most common fai lures are trading ranges and pullbacks and in both, price will usually stall . New trends tend to form very quickly and even though it is common for price to kiss the channel line goodbye, any excessive delay makes the new trend suspect. This leads us to the second way the changing of the guard takes place.

When the trend continues after pausing

A fai led reversal usually translates into a continuation of the current trend fol lowing a brief pause, such as a consolidation pattern. Pauses act as a breather and after the market is refreshed it trends to pick up where it left off. They come in various forms that you can literally spend a lifetime learning to identify and analyze. But there is no need to do all of that. They fol low the same principles of Channel Surfing as you have already learned. Most pauses have too little movement to make the actual pattern worthwhile to trade, but they stil l offer a great trading opportunity for two other reasons. 1. 2.

They predict the next leg of the trend. They offer a low risk entry.

Although they are too narrow to trade, the real value of pauses is derived by what they can tell you about any upcoming move. I f you look closely at most charts you will notice that pauses are general ly found at the center of trends. I n other words, they tend to be the halfway point of trends. So once a trend resumes, you can normally expect it to go approximately the same distance as it did in the first leg of the trend. Translated, this means that if you have a trend that started at 900 and it then paused at 950 then it is l i kely to go on to 1 000. Markets are more likely to continue than reverse direction and pauses offer a way of taking advantage of this phenomenon. But it gets better than this. Not only do you know where the market is l i kely to go, but market pauses also provide a low risk entry. Since they are generally narrow patterns to start with you will in turn have a narrow or close stop attached to your entry. A low risk entry with a defined high reward makes this pattern a favorite of many professional traders today. It is easy to see why when you look at figure 3-2.

50

Channel Surfing "

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Except on the occasion when the center line acts as support or resistance. price swings tend to be balanced by an equal swing to the opposite side of the center line

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