Monday, February 6, 2012

The elegant beauty of price channels

If it's not utterly obvious, I do hereby make an admission: I don't believe in the efficient market hypothesis (EMH), at least with regard to its ability to explain market behaviour outside the long-term. Were the EMH binding, the market price of securities would not trend; instead, they would move in a random walk. With EMH a reality, models exclusively analyzing past price behaviour of a security would struggle -- indeed, fail -- to predict future movement.

And so, it is always a revelation when I stumble upon a chart whose depicted price behaviour so cleanly conforms to the simple model of a line or a set of parallel lines (a price channel).

This evening's charts of continuous front-month silver futures (/SI) and light sweet crude oil futures (/CL), the former with hourly bars (180 d 1h) and the latter with 20-minute bars (20 d 20m), exhibit particularly striking adherence to the simple model of a price channel.

Take a look:

Front-month silver futures (/SI), 180 d 1h

Front-month light sweet crude oil futures (/CL), 20 d 20m

The elegant beauty of the price channels on these charts rests with their striking explanatory power with regard to support and resistance.

On the silver chart, the red dashed price channel neatly contains the extrema of bullish and bearish movements over the entirety of 12/29/11 to the present (2/6/12).

How could a trader use this simple model to make money? The price channel was already defined by the time price reached a local maximum of ~$34.5 on 2/2/12; thus, when price subsequently (and, incidentally, in today's trade) touched a local minimum of $33.0, a trader acting on this price channel model could have opened a profitable long position at the exact price nadir, which matched the price channel's lower support line.

It's a similar story with regard to the chart of crude oil. A trader following that chart's price channel model would also have realized a profitable long trade, entered exactly at the one-month price action low of $95.44.

Indeed, the price channel models in these charts are not only elegant in their simplicity and striking explanatory power, but downright beautiful in how cleanly and boldly they take a stand against the ivory towers' EMH.

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