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CHANNEL LINES

Using Trading Ranges To Determine Future Price Movement

11/14/03 10:26:14 AM
by Kevin Hopson

Trading ranges not only help predict future movements in price, but they can also determine the extent of the move.

Security:   EOG
Position:   N/A

Trading ranges are one of the most reliable patterns that I use in technical analysis. I do not have a reason as to why trading ranges work so well but they have allowed me to accurately predict future price movements more times than not. Just to clarify, a trading range occurs when the price of an investment vehicle is stuck between two specific levels - with one price level acting as support and the other acting as resistance. Trading ranges tend to occur after a significant move in price. Since trading ranges normally act as a consolidation pattern before the initial move (trend) continues, determining the direction of the trend prior to this formation is key.

A good example of a trading range can be seen in the following graphic, which is a six-month chart for EOG Resources (EOG). As you can see, the stock has been stuck between the $40.40 level (support) and $42.90 level (resistance) for the past three months. You will also notice that this pattern formed after EOG's bottom reversal (run-up) in August. As a result, you would expect the eventual break to be to the upside. Obviously, a significant break of the top channel line would be needed to confirm an upside breakout but assuming that this scenario plays out correctly, there is a simple way of calculating how high the stock price will go.

Graphic provided by: Stockcharts.com.
 
For example, you will notice that I have circled each time the stock tested the top and bottom channel lines over the last three months. So what is the difference between the green (larger) circles and the red (smaller) circles? The red circles indicate channel line tests that should not be counted towards our price target. There are two reasons for this. One reason is that the beginning of the trading range (or formation of the first channel line) has to occur in the direction of the trend. In other words, since EOG was moving higher prior to the formation of the trading range, the top channel line must be formed first. As a result, the first red circle does not count as the beginning of the trading range.

The reason why the two remaining red circles do not count towards our price target is because they do not occur after a test of the opposite channel line. More specifically, notice the green circles, as illustrated by pivot points 1, 2 and 3. When the stock tested the bottom channel line after pivot point 2, as indicated by the middle red circle, it did not count towards our price target. The reason being that EOG did not test the top channel line first. Pivot point 3 (last green circle) shows the successful test of this channel line later on. Also, you will notice that EOG failed to test the bottom channel line before testing the top channel line again, as illustrated by the last red circle. As a result, the recent test of the top channel line does not count towards our price target either.

So what part do these circles play in determining our price target anyway? Well, you will notice that EOG has successfully tested the top channel line twice so far (using our green circle method). If you take this number (2), multiply it by the width of the trading range ($42.90 - $40.40 = $2.50) and then add this figure ($2.50 * 2 = $5.00) to the bottom ($40.40) and top ($42.90) channel lines, you come up with a potential price target of between $45.40 and $47.90. Obviously, if the stock were to test the bottom channel line for a second time and eventually break to the downside, you would subtract this number ($5.00) from the bottom and top channel lines to get your potential downside target. In any event, by fully utilizing the trading range formation, you can predict which way prices will break in the future and just how high or low the stock will go.


Kevin Hopson

Kevin has been a technical analyst for roughly 10 years now. Previously, Kevin owned his own business and acted as a registered investment advisor, specializing in energy. He was also a freelance oil analyst for Orient Trading Co., a commodity futures trading firm in Japan. Kevin is currently a freelance writer.

Glen Allen, VA
E-mail address: hopson_1@yahoo.com

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Date: 11/15/03Rank: 4Comment: 
Date: 11/15/03Rank: 4Comment: 
Date: 11/16/03Rank: 4Comment: Kevin, how many times must the top or bottom test occur in order to determine the direction of the ensuing move?
Date: 11/18/03Rank: 4Comment: 
Date: 11/19/03Rank: 1Comment: 
Date: 12/20/03Rank: 3Comment: 
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