Investopedia/Richard Lee: Capture Profits Using Bands and Channels

Investopedia
Capture Profits Using Bands and Channels
By Richard Lee | Updated October 5, 2017 — 10:13 AM EDT
Share

Widely known for their ability to incorporate volatility and capture price action, Bollinger Bands® have been a favorite staple of traders in the FX market. However, there are other technical options that traders in the currency markets can apply to capture profitable opportunities in swing action.

Lesser-known band indicators such as Donchian channels, Keltner channels and STARC bands are all used to isolate such opportunities. Also used in the futures and options markets, these technical indicators have a lot to offer given the vast liquidity and technical nature of the FX forum.

Differing in underlying calculations and interpretations, each study is unique because it highlights different components of the price action. Here we explain how Donchian channels, Keltner channels and STARC bands work and how you can use them to your advantage in the FX market.
Donchian Channels

Donchian channels are price channel studies that are available on most charting packages and can be profitably applied by both novice and expert traders. Although the application was intended mostly for the commodity futures market, these channels can also be widely used in the FX market to capture short-term bursts or longer-term trends. Created by Richard Donchian, considered to be the father of successful trend following, the study contains the underlying currency fluctuations and aims to place profitable entries upon the start of a new trend through penetration of either the lower or upper band. Based on a 20-period moving average (and thus sometimes referred to as a moving average indicator), the application additionally establishes bands that plot the highest high and lowest low. As a result, the following signals are produced:

    A buy, or long, signal is created when the price action breaks through and closes above the upper band.
    A sell, or short, signal is created when the price action breaks through and closes below the lower band.

The theory behind the signals may seem a little confusing at first, as most traders assume that a break of the upper or lower boundary signals a reversal, but it is actually quite simple. If the current price action is able to surpass the range's high (provided enough momentum exists), then a new high will be established because an uptrend is ensuing. Conversely, if the price action can crash through the range's low, a new downtrend may be in the works. Let's look at a prime example of how this theory works in the FX markets.
Figure 1: A typical example of the effectiveness of Donchian channels
Source: FXtrek Intellicharts

In Figure 1, we see the short, one hour time-framed euro/U.S. dollar currency pair chart. We can see that, prior to December 8, the price action is contained in tight consolidation within the parameters of the bands. Then, at 2 a.m. on December 8, the price of the euro makes a run on the session and closes above the band at Point A. This is a signal for the trader to enter a long position and liquidate short positions in the market. If entered correctly, the trader will gain almost 100 pips in the short intraday burst.
Keltner Channels

Another great channel study that is used in multiple markets by all types of traders is the Keltner channel. The application was introduced by Chester W. Keltner (in his book "How To Make Money In Commodities" (1960)) and later modified by famed futures trader Linda B. Raschke. Raschke altered the application to take into account average true range calculation over 10 periods. As a result, the volatility-based technical indicator bears many similarities to Bollinger Bands®. The difference between the two studies is that Keltner's channels represent volatility using the high and low prices, while Bollinger's studies rely on the standard deviation. Nonetheless, the two studies share similar interpretations and tradable signals in the currency markets. Like Bollinger Bands®, Keltner channel signals are produced when the price action breaks above or below the channel bands. Here, however, as the price action breaks above or below the top and bottom barriers, a continuation is favored over a retracement back to the median or opposite barrier.

    If the price action breaks above the band, the trader should consider initiating long positions while liquidating short positions.
    If the price action breaks below the band, the trader should consider initiating short positions while exiting long, or buy, positions.

Let's dive further into the application by looking at the example below.
AT-Keltner21.gif
Figure 2: Three profitable opportunities are presented to the trader through Keltner.
Source: FXtrek Intellicharts

By applying the Keltner study to a daily charted British pound/Japanese yen currency cross pair we can see that the price action breaks above the upper barrier, signaling for the trader to initiate long positions. Placing effective entries, the FX trader will have the opportunity to effectively capture profitable swings higher and at the same time exit efficiently, maximizing profits. No other example is more visually stunning than the initial break above the upper barrier. Here, the trader can initiate above the close of the initial session burst above at Point A on July 17. After the initial entry is placed above the close of the session, the trader is able to capture approximately 300 pips before the price action pulls back to retest support. Subsequently, another position can be initiated at Point B, where momentum once again takes the position approximately 350 pips higher
STARC Bands

Also similar to the Bollinger Band® technical indicator, STARC (or Stoller Average Range Channels) bands are calculated to incorporate market volatility. Developed by Manning Stoller in the 1980s, the bands will contract and expand depending on the fluctuations in the average true range component. The main difference between the two interpretations is that STARC bands help to determine the higher probability trade rather than standard deviations containing the price action. Simply put, the bands will allow the trader to consider higher or lower risk opportunities rather than a return to a median.

    Price action that rises to the upper band offers a lower risk sell opportunity and a high-risk buy situation.
    Price action that declines to the lower band offers a lower risk buy opportunity and a high-risk sell situation.

This is not to say that the price action won't go against the newly initiated position; however, STARC bands do act in the trader's favor by displaying the best opportunities. If this indicator is coupled with disciplined money management, the FX enthusiast will be able to profit by taking on lower risk initiatives and minimizing losses. Let's take a look at an opportunity in the New Zealand dollar/U.S. dollar currency pair.

Figure 3: A great risk to reward is presented through this STARC bands example in the NZD/USD.
Source: FXtrek Intellicharts

Looking at the New Zealand dollar/U.S. dollar currency pair presented in Figure 3, we see that the price action has been mounting a bullish rise over the course of November, and the currency pair looks ripe for a retracement of sorts. Here, the trader can apply the STARC indicator as well as a price oscillator (Stochastic, in this case) to confirm the trade. After overlaying the STARC bands, the trader can see a low-risk sell opportunity as we approach the upper band at Point A. Waiting for the second candle in the textbook evening star formation to close, the individual can take advantage by placing an entry below the close of the session. Confirming with the downside cross in the Stochastic oscillator, Point X, the trader will be able to profit almost 150 pips in the day's session as the currency plummets from 0.7150 to an even 0.7000 figure. Notice that the price action touches the lower band at that point, signaling a low-risk buy opportunity or a potential reversal in the short-term trend.
Putting It All Together

Now that we've examined trading opportunities using channel-based technical indicators, it's time to take a detailed look at two more examples and to explain how to capture such profit windfalls.

In Figure 4 we see a great short-term opportunity in the British pound/Swiss franc currency cross pair. We'll put the Donchian technical indicator to work and go through the process step by step.

Figure 4: Applying the Donchian channel study, we see a couple of extremely profitable opportunities in the short time frame of a one-hour chart.
Source: FXtrek Intellicharts

These are the steps to follow:

1. Apply the Donchian channel study on the price action. Once the indicator is applied, the opportunities should be clearly visible, as you are looking to isolate periods where the price action breaks above or below the study's bands.

2. Wait for the close of the session that is potentially above or below the band. A close is needed for the setup as the pending action could very well revert back within the band's parameters, ultimately nullifying the trade.

3. Place the entry at slightly above or below the close. Once momentum has taken over, the directional bias should push the price past the close.

4. Always use stop management. Once the entry has been executed, the stop should always be considered, as in any other situation.

Applying the Donchian study in Figure 4, we find that there have been several profitable opportunities in the short time span. Point A is a prime example: here, the session closes below the bottom channel, lending to a downside trend. As a result, the entry is placed at the low of the session after the close, at 2.2777. The subsequent stop will be placed slightly above the high of the session, at 2.2847. Once you are in the market, you can either liquidate your short position on the first leg down or hold on to the sell. Ideally, the position would be held in retaining a legitimate risk to reward ratio. However, in the event the position is closed, you may consider a re-initiation at Point B. Ultimately, the trade will profit over 120 pips, justifying the high stop.

Defining a Keltner Opportunity
It's not just Donchians that are used to capture profitable opportunities – Keltner applications can be used as well. Taking the step-by-step approach, let's define a Keltner opportunity:

1. Overlay the Keltner channel indicator onto the price action. As with the Donchian example, the opportunities should be clearly visible, as you are looking for penetration of the upper or lower bands.

2. Establish a session close of the candle that is the closest or within the channel's parameters.

3. Place the entry four to five points below the high or low of the session's candle.

4. Money management is applied by placing a stop slightly below the session's low or above the session's high price.

Let's apply these steps to the British pound/U.S. dollar example below.
AT-Keltner41.gif
Figure 5: A tricky but profitable catch using the Keltner channel
Source: FXtrek Intellicharts

In Figure 5, we see a very profitable opportunity in the British pound/U.S. dollar major currency pair on the daily time frame. Already testing the upper barrier twice in recent weeks, the trader can see a third attempt as the price action rises on July 27 at Point A. What needs to be obtained at this point is a definitive close above the barrier, constituting a break above and signaling the initiation of a long position.

Once the chartist receives the clear break and closes above the barrier, the entry will be placed five points above the high of the closed session (entry). This will ensure that momentum is on the side of the trade and the advance will continue. The notion will place our entry precisely at 1.8671. Subsequently, our stop will be placed below the low price by one to two points, or in this case at 1.8535. The trade pays off as the price action moves higher in the following weeks with our profits maximized at the move's high of 1.9128. Giving us a profit of over 400 pips in less than a month, the risk reward is maximized at more than a 3:1 ratio.
The Bottom Line

Although Bollinger Bands® are more widely known, Donchian channels, Keltner channels and STARC bands have proved to offer comparably profitable opportunities. By diversifying your knowledge and experience in different band-based indicators, you'll be able to seek a multitude of other opportunities in the FX market. These lesser-known bands can add to the repertoire of both the novice and the seasoned trader.
Related Articles

    Trading
    Trading Volatile Stocks with Technical Indicators
    Short-term traders seek volatility because of the profit potential, which leads to two common questions. How do I find volatile stocks? And how do I use technical indicators to trade them? Find ...
    Trading
    Discovering Keltner Channels and the Chaikin Oscillator
    It's time to acquaint yourself with some lesser-known yet effective technical indicators.
    Trading
    The Basics Of Bollinger Bands®
    This strategy has become one of the most useful tools for spotlighting extreme short-term price moves.
    Trading
    Moving Average Envelopes: Refining A Popular Trading Tool
    Traders can benefit from experimenting with envelopes, which help spot trends after they develop.
    Trading
    Moving Average Explosions
    Find out how you can profit from this short squeeze strategy.
    Trading
    Traders: Profit From Other Investors' Fear
    Learn to pounce on the opportunity that arises when other traders run and hide.
    Trading
    Tales From The Trenches: A Simple Bollinger Band® Strategy
    Spot extreme short-term price drops and profit on the rebound.
    Trading
    Buy These Stocks on The Pullback (LEN, FNF)
    These four stocks are in upward sloping trend channels and have recently pulled back toward the bottom of the channel, providing a buying opportunity.
    Trading
    Channeling: Charting A Path To Success
    Find out how to build these charts showing buy, sell, stop-loss and take-profit points, and even estimate length of trade.
    Trading
    Uncover Forex Profits With The Turn Trade
    Pick tops and bottoms while still trading within the overall framework of a trend.

RELATED FAQS

    What are the differences between Bollinger Bands® and Donchian Channels?
    Read about the primary differences between Bollinger Bands and Donchian Channels, two technical price charting tools used ... Read Answer >>
    Why are STARC Bands important for traders and analysts?
    Learn what STARC bands are and how the rationale behind their construction provides helpful indications for traders and market ... Read Answer >>
    What does it mean when a stock is trading near the Donchian channel, high or low?
    Learn how Donchian channels can be used to spot overbought or oversold positions and how to react to these signals to make ... Read Answer >>
    What's the difference between Bollinger Bands® and Keltner Channels?
    In technical analysis, there is a small difference between Keltner Channels and Bollinger Bands®. We'll explain it for you ... Read Answer >>
    What is the formula for Donchian channels and how is it calculated?
    Discover how technical analysts calculate the formula for the Donchian Channel, a moving average indicator created by Richard ... Read Answer >>
    What are the best technical indicators that complement the STARC Bands?
    Discover some of the best technical indicators that can be used to complement a trading strategy designed primarily with ... Read Answer >>

Trending

    Stock Strategies for a Highly Volatile Market
    Is Someone Manipulating the VIX?
    20 Must-Read Books for Finance Professionals
    The Market Is Crashing. Please Explain What All of These Words Mean
    9 Common Effects of Inflation

Hot Definitions

    Donchian Channels
    Consumer Price Index - CPI
    Moving Average - MA
    Stop Order
    Inflation
    Candlestick

    Work With Investopedia
    About Us Advertise With Us Contact Us Careers

© 2018, Investopedia, LLC. Feedback All Rights Reserved Terms Of Use Privacy Policy