The Evolution Of The Euro's Trend Channel

11/12/03 02:54:14 PM

by David Penn

The dramatic fall and fall and rise of the EUR/USD as seen through the lens of a trend channel.

Security: EURUSD
Position: N/A

What is the function of a trend channel? John Bollinger once said that the conventional method of drawing trendlines under the lows during uptrends and above the highs during downtrends was backwards. Instead, Bollinger provocatively suggested, trendlines should be drawn above the highs during uptrends to better understand the upside potential in the trend. Conversely, Bollinger added that trendlines under the lows during downtrends would provide traders and market analysts with a superior sense of the intensity of the downward price action.

While this might seem like mere clever counterintuitiveness from a master technician, those who use trend channels have long seen the wisdom in Bollinger's remarks. A trend channel, useful during trending markets, consists of a pair of parallel lines that encompass the highs and lows of a given trend and, as Bollinger's comments suggest, can provide great insights into the intensity -- and possible over-extension -- of a trend.

The trend channel that encompassed price action in the euro from late October into early November is a particularly worthwhile case for review. The trend channel initially contained euro price action as the euro began moving down on October 24th from a peak of 1.1850. The upper and lower bands of this trend channel have been tested repeatedly during the decline: to the downside on October 28th and to the upside on October 30th. Yet, prices continued to be contained in the channel.

The breaking of the lower band of this trend channel was a clue to euro bears that the market was changing. Prices headed lower for a few days, but rallied sharply to break through both the lower and, eventually, the upper bands of the trend channel in a sharp, sudden advance.

Graphic provided by: eSignal.

That is, price continued to be contained in the channel until the sharp hourly break on November 3rd, as the euro plunged from 1.1581 to 1.1460 -- a move of 121 points. This break ejected the euro from the price channel it had been operating in for the past few weeks, and anticipated lower prices going forward. The euro moved sluggishly lower, with each minor rally bumping against the lower band of the trend channel -- which had changed from support to resistance with the November 3rd break. By November 7th, the euro had drifted down to 1.1374.

Would the euro continue downward? Just as a descending triangle appeared to be in the making, the euro rose sharply and suddenly, bursting back into the old trend channel and violating resistance to the upside. Even as the market moved largely sideways in the wake of the sizable spike off the lows, it was important to realize that the next major test would come when the euro moved up toward resistance at the upper band of trend channel. It took the euro a few days to do this, but this is exactly what it did on November 11th in another strong hourly upmove. In this case, the euro even briefly tested the upper band of the trend channel in the 1.1550 area before continuing to move higher.

One of the good things about the trend channel is that it helps underscore when a trend has ended, when a bottoming process is occurring and when a new trend has begun. Clearly the initial downtrend that began on October 24th had changed. Although it appeared to be actually deepening at the time (i.e., the trend becoming more steeply downward), the fact that the old trend was over was reason to be wary of a possible reversal or, at minimum, a sideways consolidation that would see the euro going nowhere fast for too long a period. By re-entering the trend channel and beginning to move sideways, the risks of a sideways consolidation became greater and the possibility that the euro was forming a bottom -- however temporary it might be -- was increasing. When prices broke through the upper band of the old trend channel, the bottom was truly in evidence, and the question shifted to the strength of the new, confirmed uptrend.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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The Evolution Of The Euro's Trend Channel

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