Markets are manic-depressive beasts. They rise in powerful rallies, only to collapse in breathtaking declines. A stock catches the public's fancy, shoots up 20 points one day, and then slides 24 points down the next. What drives those moves? Fundamental values change slowly, but waves of greed, fear, optimism, and despair drive prices up and down.

How can you tell when a market has reached an undervalued or over valued level, a zone for buying or selling? Market technicians can use channels to find those levels. A channel, or an envelope, consists of two lines, one above and one below a moving average. There are two main types of channels: straight envelopes and standard deviation channels, also known as Bollinger bands.

In Bollinger bands the spread between the upper and lower lines keeps changing in response to volatility. When volatility rises, Bollinger bands spread wide, but when markets become sleepy, those bands start squeez- ing the moving average. This feature makes them useful for options traders since volatility drives options prices. In a nutshell, when Bollinger bands become narrow, volatility is low, and options should be bought. When they swing far apart, volatility is high, and options should be sold or written.

Traders of stocks and futures are better off with straight channels or envelopes. They keep a steady distance from a moving average, provid ing steadier price targets. Draw both lines a certain percentage above or below the EMA. If you use dual moving averages, draw channel lines parallel to the longer one.

A moving average reflects the average consensus of value, but what is the meaning of a channel? The upper channel line reflects the power of bulls to push prices above the average consensus of value. It marks the normal limit of market optimism. The lower channel line reflects the power of bears to push prices below the average consensus of value. It marks the normal limit of market pessimism. A well-drawn channel helps diagnose mania and depression. Most software programs draw channels according to this formula:

Upper channel line = EMA + EMA * Channel coefficient Lower channel line = EMA - EMA * Channel coefficient

A well-drawn channel contains the bulk of prices, with only a few extremes poking out. Adjust the coefficient until the channel contains approximately 95 percent of all prices for the past several months. Mathe maticians call this the second standard deviation channel. Most software packages make this adjustment very easy.

Find proper channel coefficients for any market by trial and error. Keep adjusting them until the channel holds approximately 95% of all data, with only the highest tops and the lowest bottoms sticking out. Drawing a chan nel is like trying on a shirt. Choose the size in which the entire body fits comfortably, with only the wrists and the neck poking out.

Different trading vehicles and timeframes require different channel widths. Volatile markets require wider channels and higher coefficients. The longer the timeframe, the wider the channel; weekly channels tend to be twice as wide as dailies. Stocks tend to require wider channels than futures. A good time to review and adjust channels in futures is when an old contract nears expiration and you switch to the new front month.

A channel drawn in an uptrend tends to fit the peaks. Rallies in a bull stock market are much stronger than declines, and bottoms seldom reach the lower channel line. In a downtrend, a channel tends to track bottoms, while the tops are too limp to rise to the upper channel line. It is unnecessary to draw two separate channels, one for the tops and the other for the bottoms; just follow the dominant crowd. In a flat market expect both tops and bottoms to touch their channel lines.

When we are bullish, we want to buy stock value near the rising EMA and take profits when the market becomes overvalued-at or above the upper chan-nel line. When bearish, we want to go short near the falling EMA and cover when the market becomes undervalued-at or below the lower channel line.

If you buy near a rising moving average, take profits in the vicinity of the upper channel line. If you sell short near a falling moving average, cover in the vicinity of the lower channel line. Channels catch swings above and below value but not major trends. Those swings can be very rewarding. If you can catch a move from the EMA to the channel line in bond futures, you'll make about $2,000 in profit on a $2,000 margin. If you can do this a few times a year, you'll find yourself far ahead of many professionals.

A beginner who sells his position near the upper channel line may regret it several weeks later. In a bull market, what looks overvalued today may look like a bargain the next month. Professionals do not let such feel ings bother them. They are trading, not making investment. They know it's easy to be smart looking at old charts, but hard to make decisions at the right edge. They have a system, and they follow it.

When prices blow out of a channel but then return to the moving aver- age, trade in the direction of the slope of that MA, with a profit target near the channel line. Prices break out of channels only during the strongest trends. After they pull back, they often retest the extremes of those break-outs. A breakout from a channel gives us confidence to trade again in its direction.

Prices occasionally take off on wild runaway trends. They break out of a channel and stay out for a long time, without pulling back to their EMA. When you recognize such a powerful move, you have a choice: stand aside or switch to a system for stock trading impulse moves. Professional traders, once they find a technique that works for them, tend to stay with it. They'd rather miss a trade than change to an unfamiliar style.

If a moving average is essentially flat, go long at the lower channel line, sell short at the upper channel line, and take profits when prices return to their moving average. The upper channel line marks an overbought zone. If the market is relatively flat on long-term charts, rallies to the upper channel line then provide shorting opportunities, whereas declines to the lower channel line provide buying opportunities. Professionals tend to trade against deviations and for the return to normalcy. Amateurs think that every breakout will be followed by a massive runaway move. Once in a rare while the amateurs are right, but in the long run it pays to bet like the pros. They use channels to find when the market has outrun itself and where it is likely to reverse.

How to Grade Your Performance Imagine two friends taking a college course. Both have similar abilities and backgrounds, but one takes a test each week, while the other waits for a final. All other factors being equal, which of them is likely to get a higher grade on the exam? The one who waited or the one who took weekly tests?

Most educational systems test students at regular intervals. Testing prompts people to fill the gaps in their knowledge. Students who take tests throughout the year tend to do better on their finals. Frequent tests help improve performance.

Markets keep testing us, only most traders don't bother to look up their grades. They gloat over profits or trash confirmation slips for losing trades. Neither bragging nor beating yourself makes you a better trader.

The market grades every trade and posts results on a wall, only most traders have no clue where to look. Some count money, but that's a very crude measure, which does not compare performance in different markets at different prices. You may take more money from a sloppy trade in a big expensive market than from an elegant entry and exit in a difficult narrow market. Which of them reveals a higher level of skill? Money is important but it doesn't always provide the best measure of success.

Channels help us grade the quality of our trades.

When you enter a trade, measure the height of the channel from the upper to the lower line. If you use daily charts to find trades, measure the daily channel; if you use a 10-minute chart, measure the channel on a 10- minute chart; and so on. When you exit that trade, calculate the number of points you've taken as a percentage of the channel. That is your per-formance grade.

If a stock is trading at 80 with a 10% channel, then the upper channel line is at 88 and the lower at 72. Suppose you buy that stock at 80 and sell it at 84. If you take 4 points out of the 16-point channel, then your grade is 4 / 16 or 25%. Where does that place you on the rating curve?

Any trade where you take 30% or more out of a channel earns you an

A. If you take between 20 and 30%, your grade is a solid B. If you grab between 10 and 20%, you earn a C. You get a D by taking less than 10% out of a channel or running a loss.

Good traders keep good records. Your first essential record is a spread- sheet of all your trades (we'll review this in Chapter 8, "The Organized Trader"). Add two columns to your spreadsheet. Use the first to record the height of the channel when you enter the trade. Use the second to calculate what percentage of that channel you've grabbed exiting that trade. Keep mon- itoring your grades to see whether your performance is improving or deteri- orating, steady or erratic. Back in college, professors used to grade you. Now you can use channels to find out your grades and become a better trader.

What Markets to Trade? Channels can help us decide which stocks or futures to trade and which to leave alone. A stock may have great funda mentals or beautiful technical signals, but measure its channel before you put on a trade. It'll show you whether the swings are wide enough to be worth trading.

You may look at a volatile stock whose channel height is 30 points. If you are an A trader, you should be able to get 30%, or 9 points, out of a trade. That will be more than enough to pay commissions, cover slippage, and leave you with profits. On the other hand, if you look at an inexpen sive stock whose channel is only 5 points high, then an A trader would be shooting for a paltry 1.5-point gain. That would leave you with next to nothing after commissions and slippage-leave that stock alone, no mat ter how good it looks.

What if your performance slips a bit or the market throws you a curve? What if you earn only a C and take only 10% out of a channel? The first stock, with its 30-point channel, will return 3 points profit-enough to make some money after expenses. The stock with a 5-point channel will return only half a point, and commissions and slippage may push you into nega- tive territory! Beginners are often seduced by low-priced stocks with strong technical patterns. They cannot understand why they keep losing money. When there is no room for the stock to swing, a trader can't win.

A good technical analyst who was slowly losing money called me for a consultation. When I asked him to fax me his charts, he showed $10 and $15 stocks whose channels were only $2 to $4 tall. There was simply no room for price swings, while commissions, slippage, and expenses continued to chip away at his equity. If you're going to support yourself by fishing, find a channel where the fish are big enough.

Once you become interested in a new stock, draw a channel to see whether it's wide enough to trade. We like to think of ourselves as A traders and all-around A people, but what if you pull only a C trade? If you take only 10 percent out of this channel, will it be worth trading? Beginning traders should leave alone any stock whose channel is narrower than 10 points, meaning that a C trader can take one point out of it.

A few traders said to me it was OK to trade stocks with narrrow chan- nels, as long as one increased trading size. They think that trading 10,000 shares in a three-point channel is the same as trading 1,000 shares in a 30-point channel, but it is not, because the ratio of slippage to channel is much higher in narrow channels, raising the external barrier to victory.

Low-priced stocks with slender channels can make good investments. Think of Peter Lynch, a famous money manager, looking for his elusive 10-bagger, a stock that goes up 10-fold. A $5 stock is much more likely to rise to $50 than an $80 stock to rally to $800. But those are investments, not trades. As a trader, you are looking to take advantage of short-term swings. That is why you should not waste your energy on any stock whose channel is narrow.

The Rewards of Day-Trading Day-trading seems deceptively easy, and beginners flock to it like moths to a flame. Amateurs look at intraday charts and see strong rallies and steep declines. It looks like the money is there for the picking by any sharp-witted individual with a computer, a modem, and a live data feed. Day-trading firms make fortunes in commissions. They promote day-trading because they need to replace the great majority of cus- tomers who flame out. The firms hide customer statistics from the public, but in the year 2000 state regulators in Massachusetts subpoenaed records which showed that after 6 months only 16% of day-traders made money.

There is an old Russian saying: "your elbow is near, yet you can't bite it." Try it now-stretch your neck, bend your arm, go for it. So near, yet so far. It's the same with day-trading-the money is right in front of your face, yet you keep missing it by a few ticks. Why do so many people lose so much money day-trading? There is simply not enough height in intra day channels to make profits. Using channels to select trades sends a powerful message to day-traders.

Look at a few popular actively traded stocks-YHOO, AMZN, and AOL are in the forefront of public attention on the day I write this. The figures are likely to change by the time you read this book, but today I get the follow-ing numbers for channel heights on their daily and five-minute charts:

Recreational day-traders who expect to make money are deluding them selves into believing that they will reach their elbow with their teeth. Maybe tomorrow

A swing trader who uses daily charts to buy and hold for a few days can do very well in these active stocks. He can really clean up if he is an A-level trader, but even if he is a C trader, taking 10% out of a channel, he can stay afloat while he's learning. A person who day-trades the same stocks must be a straight-A trader in order to survive. Anything less, and he'll be eaten alive by slippage, commissions, and expenses.

I can hear a howl of protests from the crowd of vendors who make a good living from day-trading-brokers, software dealers, system sellers, etc. They can roll out their examples of successful day-traders, as if that proves anything! Brilliant day-traders do exist, and I am friends with a handful of them myself. Sadly, it's a very small handful.

The chances of becoming a successful day-trader are very low because the channels on intraday charts are not high enough. You must be a straight-A trader to make money out of those minute swings. The slightest distraction, a bit of market noise, a slight slip of performance, and another day-trader bites the dust.

Day-trading provides fantastic entertainment value. Recreational ath- letes expect to pay for their sport rather than make money from it.