Price Action: Microchannels (Part 3)

There are three common environments in which microchannels appear, and the approach differs greatly depending on the context.

The first is a bull microchannel appearing in a bullish environment.

The goal is usually to counter-trade — expecting the counter-trend breakout to fail and price to resume upward. The real difficulty is not in identifying the microchannel but in confirming that the current market is indeed in a bullish environment. A bullish environment could be within a larger bull trend, or it could be a temporary rally within a larger bear trend.

Not all bull microchannels are of equal quality. If the channel consists of consecutive strong bull bars, pullbacks are usually shallow; but if each breakout bar is followed by a pause bar, the quality is much weaker and pullbacks will be deeper, especially when it appears in the second or third leg of a move. Factors affecting probability include the leg count (later legs have lower success rates); the phase of the market cycle (breakout phase, channel phase, or consolidation phase); and internal structure (whether bars are tightly packed, whether there are opposing-color bars, etc.).

The second is a bull microchannel appearing in a bearish environment. This type of situation is usually a bear flag, and the higher probability is to trade in the bear direction — expecting the counter-trend breakout to succeed. However, if the bull microchannel is very strong, the first breakout may also fail, so the safer approach is often to wait for the breakout and pullback before taking a second entry. For example, in a bear trend where a microchannel of three to four bull bars appears, you can wait for the first downward break to fail, then wait for the price to attempt a rally that also fails, and go short on the second break. This avoids the risk of directly fighting a strong channel.

The third is a bull microchannel appearing in a consolidation environment. In this case, first determine whether price is at the high or low of the trading range. If at the low, lean toward counter-trading long, expecting the counter-trend breakout to fail and price to go up. If at the high, lean toward going short, but it is best to wait until a false breakout at the high followed by a pullback before entering, rather than entering on the first breakout. The more advanced approach is to look for trap prices at trading range highs or lows — positions where the other side's traders are trapped — since taking the opposite side at these prices has a higher success rate.

A microchannel breakout specifically refers to a counter-trend breakout — such as a bull microchannel broken downward, or a bear microchannel broken upward. After a counter-trend breakout, there are four common outcomes. The first is a successful breakout where price continues in the breakout direction. For scalpers, success may just mean a tradable second leg; for swing traders, success may mean a complete trend reversal to a new extreme. You must clarify your goal before entering — scalp or swing — as this defines your measure of success. The second is a failed breakout that resumes the original trend, where the counter-trend breakout lacks momentum and is quickly absorbed by the original trend, turning the breakout into a pullback. The third is a failure of the failure, where the breakout fails and the original trend resumes, but the resumption also fails, forming a breakout pullback continuation in the breakout direction — typically called a second entry opportunity. The fourth is a failed breakout entering consolidation, where the counter-trend momentum is significant but insufficient to reverse the trend, and price enters a sideways mode that usually eventually goes in the original trend direction, though the longer the sideways period, the closer the directional probability approaches 50/50.

A counter-trend breakout can be understood as a reversal attempt, so the corresponding outcomes are: successful reversal, failed reversal, failure of the failed reversal, and failed reversal entering consolidation. The importance of microchannels lies in the fact that their quality and location provide critical clues about the probability of breakout success or failure. Quality includes bar consistency, degree of overlap, whether there are opposing-color bars, etc.; location includes which phase of the trend it is in, and whether it is at the high or low of a trading range. This information helps traders determine whether to trade in the breakout direction or counter-trade, and whether the breakout will likely succeed on the first attempt or require a second opportunity.