Invest and Trade Profitably with Jon Johnson

Please describe how you determine the first and second upper channel lines. If possible could you provide an example chart.

August 30, 2000

Upper channel lines tend to be very accurate predictors of pullbacks and bounces during solid uptrends and downtrends. They are plotted to help determine when a stock is ready to pull back after it’s been in an uptrend for several weeks or months, making them an important technical analysis tool in designating target prices as well as when an uptrend has begun to run out of steam. We use them to measure whether the stock is climbing ahead of itself and setting up for a sell-off. When used in conjunction with short-term trendlines, we can see if a stock is in a blow-off top. This is when a stock rises 2-3% over the upper channel on extreme volume (usually the highest in the run or in the past year) and gains 50-100% in a short time. This results in a fast and usually deep sell-off. Search ‘blow-off top’ in the Education Center.

To plot the upper channel line, connect at least three highs as the stock trends upward. The more you connect the better; 2 points can make a line, but the more points, the stronger the line. The line then should slope upward, and run parallel to the up trendline, which connects the stock’s lows as it moves higher. As your question suggests, and as we have stated in discussing NASDAQ’s chart, there can be more than one upper channel. Sometimes a stock will rise above an established channel on occasion while still moving predominantly in the lower channel. That can create another, higher channel line that is almost a sure sign of a steeper pullback. NASDAQ created its primary (first) upper channel line coming out of the March dip. It formed the line with the May high. In June it jumped over that line, fell back, and then did so again in July. That set off a deeper correction to the up trendline. It again tested the first and second channel in September, but after that has been sticking to tests of the first channel.

As a rule of thumb, as a run gets older the moves higher peak out lower (in this case at the first channel line) because the buying is typically not as intense as it is when the run kicks off. Then, when the run is peaking, you may see another spike of volatility where the stock or index jumps up to the higher channel and sells off rather abruptly. When we see that the odds of a longer correction or consolidation as opposed to just a test of the trendline and a sharp bounce from there. Indeed, if we saw NASDAQ race higher from here and fail at the upper channel, that would be a signal to take some money off the table as a precaution. At a minimum you would most likely get some better entry points on stocks after a quick pullback. More than likely you preserve some good gain, particularly with option plays, as the index tests and then consolidates for a more extended time period.

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