Trade against the trend – how it works
The clever catching of a falling knife
Kitchen and stock-exchange have actually not a lot in common. But who catches a falling knife, can be “injured” in both sides. Market-exaggerations can provide excellent trading opportunities. One possibility to take advantage of such situations is the so-called Channel Buster.
What is a Channel Buster?
Channel Buster is a Trading Setup of the Chart-technique. In an established upward or downward trend-channel, an exceeding or deceeding of the channel in the direction of the trend. The channel is, so to speak, broken, and as the name suggests, there is a Channel Buster. In this case, there are only two possibilities: either the overriding trend continues with a higher intensity or there is at least a temporary exhaustion. If it is the second case, then there is an overbought situation in the upward trend and an oversold situation in the downward trend, where the prices jump back to the original trend-channel. Thus an entry signal for Channel Buster is triggered. Market participants, who have positioned themselves very late or even at the break of the trend channel in the trend direction, are then confronted with a loss. They close their position and turn them if necessary. Like a rubber band that has been extended too far, the prices snap back quickly. The more significant the break of the channel-line the more violent may be the counter-movement. The result is often a sharp counter rally in the form of a pullback, or even the beginning of a change in the trend which allows high profit potential in a short time window. However, explicit price targets cannot be derived. Accordingly, the Channel Buster is attributable to the classic swing-trading. The setup requires two essential things:
1. A high attention, constantly to check early existing trends because the biggest gain-potential is usually at the beginning of the trend.
2. Mental strength because Channel Buster often occur at the end of long trends while the media environment generally propagates a trend continuation. Swimming against the current requires a high intellectual flexibility and strength. At the same time it violates two rules of technical analysis. First, one enters a position without sufficient evidence of a bottoming in accordance with the rules of technical analysis. Secondly, one disregards the trend-following-approach. You have to buy in phases of weakness and sell in phases of strength. Therefore, the Channel Buster demands also rethinking of traditional concepts.
The rules are simple
The basic idea of the Channel Busters is easy. It involves the identification of a chart signal. It is important to observe the following rules in advance of the Entry:
1. The trader Cliff Droke describes in his book "Channel Buster" as the ideal trend channel, which is crucial for identifying the right Setup. The trend channel should be not too steep, because such a channel would be broken in a progressive duration. Thus, the significance of a trend-break decreases. Better is a relatively flat and constant trend channel that has been established over a longer period. In hourly chart that would be at least several days. When working in the daily chart, six weeks would be needed. The longer a prevailing trend continues, the higher the probability that exhaustion takes place in a Channel Buster, which can be traded profitably.
2. Channel Busters are more common in downtrends and easier to trade than their counterparts in uptrend. This may be because there may be quite high liquidations in panic phases, which quickly lead to a temporary exhaustion of selling pressure. In the opposite situation, Momentum is built for a longer period, so that the upward movement does not come so quickly to a halt. This makes it difficult to set a counter-trade.
Case Study of Long Entry
If you trade the Long-Entry in a Channel-Buster – the so-called "falling knife" – following rules apply that can be generalized. As a practical example we use the situation in the DAX from February this year (Figure 1).
Point A: The DAX closed on 11/02 at 8756.87 points below the downtrend channel since the beginning of December. There is a Channel Buster.
Point B: The next day (there can be several), the price takes back the channel-line also on a closing basis. The long entry follows on 12/02/2015 at 8967.51 points.
Point C: The stop loss is set just below the day's low of Channel Busters (8697.19 points) and remains there usually for two to three days (blue line). In the initial stage of the trend there is often higher volatility observed as bull and bear fight at this point to change the direction. By a too quick tightening of the stop-loss, you can be thrown out of a good position. However, a resumption of the downward trend cannot be excluded, so that after the initial Entry-phase you go over to a basically narrow Stop-loss management.
Point D: As first minimum target applies the important previous minor low (green line) at 9326.20 points.
Point E: The upper-downtrend-channel-boundary is the second exit point. By achieving these marks the parent downtrend can be again initiated. From there, a continuous tightening of the stop-loss below the day's low of the last candlestick is advisable.
Point F: With this stop-loss strategy you would exit on 19/02/2016 at 9388.05 points and you would have achieved within five trading days a profit of 420.54 points or 4.7 percent. Even at the breakout of the trend-channel and a perspective trend-reversal, the maintaining this system would be justified in order to secure existing gains.
Practical example of short entry
Conversely, the example of Allianz AG from 2015 represents the criteria for a short entry (Figure 2).
Point A: The stock has established a medium term uptrend channel since the low in October. On 04.10.2015 due to a large green candle follows the breakout above the upper-uptrend- channel-limit on a closing basis. A Channel Buster is there.
Point B: On the fourth day of the breakout, the prices fall back in the original trend channel. A short entry on 15/04/2015 at 168.15 euro follows.
Point C: The stop-loss is set just above the day’s highs of the highest Candlesticks above the trend channel; in this case, at 170.13 euros (green line).
Point D: Again, as a minimum target applies the first significant support at 162.52 euros (blue line). This is followed by a second at 160.47 euros, which is at the lower-uptrend- channel-limit (point E). Also in this example, a tight stop-loss management should be applied because there is no guarantee that the parent trend will not be re-established. The stop-loss is set just above the day's high of the last candlestick.
Point F: with this strategy you would have been stopped in this example, only on 05.04.2015 at a price of 154.85 euros and would have an unleveraged profit of 13,30 Euro (8.5 percent). With a more flexible stop-loss management one could have stayed longer in the trade.
Strategy is not a sure-fire success
As with any trading strategy, there is no 100-percent success rate. After a Channel Buster, there is always the possibility that in strong downtrend or uptrend the dominant direction starts again in the shortest time. The example of the Commerzbank AG in May 2013 (Figure 3) shows that four days after the Entry-signal, the trade fails and the downtrend resumes. A stop-loss (green line) in accordance with the previously discussed strategy led even to a small profit, and preserved from all losses.
Conclusion
The Channel Buster can be an extremely profitable trading strategy in volatile times. However, a successful implementation requires great care and mental strength and the flexibility to move away from traditional concepts of technical analysis. Due to the risk that the dominant trend at any time can be resumed, a disciplined stop-loss management is central in order to use Channel Buster successfully. Otherwise, you can still be “injured” when catching the “falling knife”.
Jörg Rohmann worked as a strategist and analyst for Europe's largest energy trader and for an international foreign exchange broker. He focuses on technical chart trading strategies and acts as a freelance writer in the financial sector. He also operates the trading and investment blog www.armoredhorse.com
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