Channels are a more sophisticated approach to predicting how far a trend will move than simple trend lines. In short, channel lines do not only consist of one trend line, but of two parallel lines. One line is the conventional trend line, limiting upwards trends to the downside and downwards trends to the upside. The second line is a parallel line to the trend line that limits the trend to the other side of the trend line.
For most traders, this concept is easy to grasp. It offers some obvious advantages, and allows for easier and more accurate predictions. Some traders, however, struggle with the idea of channel lines having to be parallel. They ask why the line limiting the trend to the upside and the line limiting the trend to the downside have to be parallel, and which law can guarantee them that this will always be the case.
Possible explanations for channel lines
Unfortunately, such a law does not exist. In fact, there is no certain explanation why highs and lows in a trend occur on parallel lines. There are, however, some attempts at an explanation:
1) Trading fundamentals
When trading range and volume are stable, an orderly, parallel channel is the only possible result. The market will move up and down for the same time and the same speed with every swing, which can only result in a parallel channel. In short, this explanation assumes that, if 2 plus 2 equaled 4 once, it will keep equaling 4 until the basic equation changes. This means, the trend will move in orderly, parallel lines until a significant event changes the trend and creates new parallel lines.
Some traders believe that all market movements are the result of ever recurring market cycles. While they also admit that there are too many cycles to predict which one will affect the market in the near future. Trends, in their mind, are the results of cycles, too. If this is true, channel lines in a trend are created by the same cycles over and over again, and, therefore, have to be parallel. They will keep moving in parallel line until another cycle influence the market and creates a new trend.
The third explanation uses a psychological approach. To know whether the market will move up or down, traders have to classify the market into high and low prices. Much like an oscillator they therefore set an upper limit over which they will not invest in an asset, and a lower limit under which they will not sell. After the price has moved some time, traders will automatically feel that the market is moving too far in one direction. Therefore, they will stop selling / buying, and the market will turn around.
According to this explanation, each swing is limited by the traders feeling for high and low prices. While these feelings can change over time, these changes take time. Since the flexibility of traders remains constant, highs and lows will rise or fall at a fixed speed. This creates parallel trend lines.
So, which explanation is right?
Unfortunately, there is no way of knowing which explanation is right. Fortunately, on the other hand, this does not matter. What matters is that channel lines are almost always parallel and that there are several reasons that explain why – maybe they are all true. Always remember the basic assumption of technical analysis: If you know what will happen, you do not need to know why.
Nonetheless – be alert when using channels for trends. Trends constantly gain and lose momentum. Therefore, channels might not be reliable for too long and change angles often. Successful traders do not try to make the market fit a certain channel expectation they have, they make their channels fit the reality of the market.