Channel surfing

Channel Surfing
Riding the Waves
of Channels to Profitable Trading

by
Michael J. Parsons

authOrrlOUSE"

1663 £tHER7Y DRIVE, SUITE 200
BLOOMINGTON, INDIANA 47403
(800) 839-8640
wwW.AUTHORHouSE.COM


© 2005 Michael J. Parsons. All Rights Reserved.
No part of this book may be reproduced, stored in a retrieval system, or transmitted by
any means without the written permission of the author.

First published by AuthorHouse 03/16/05

ISBN: 1-4208-3312-X (sc)

Printed in the United States of America
Bloomington, Indiana

This book is printed on acid-free paper.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used
their best efforts in preparing this book, they make no representations or warranties

with respect to the accuracy or completeness of the contents of this book and specifi­
cally disclaim any implied warranties of merchantability orfitness for a particular pur­
pose. No warranty may be created or extended by sales representatives or wrillen sales
materials. The advice and strategies contained herein may not be suitable for your situ­
ation. You should consult with a professional where appropriate. Neither the publisher
nor the author shall be liable for any loss of profit or any other commercial damages,
including but not limited to special, incidental, consequential, or other damages.
It should not be assumed that the methods, techniques, or indicators presented in this
book will be profitable or that they will not result in losses. Past results are not neces­
sarily indicative of future results. Examples in this book are for educational purposes
only. This is not a solicitation of any order to buy or sell.
The National Futures Association (NFA) requires us to state that "Hypothetical or
simulated performance results have certain inherent limitations. Unlike an actual
performance record, simulated results do not represent actual trading. Also, since the
trades have not actually been executed, the results may have under or over compensat­
ed for the impact, if any, of certain market factors, such as lack of liquidity. Simulated
trading programs in general are also subject to the fact that they are designed with the
benefit of hindsight. No representation is being made that any account will or is likely
to achieve proi
f ts or losses similar to these shown."


To my mother Peggy whose legacy still impacts this world
for good more than a quarter of a century after she left
it and my wife Ruth who stood by me through all the
good, the bad and the ugly this world had to offer.

v

Table of Contents
1.

Channel Surfing - The Basic Concept . .

2.

Break ing Waves

3.

Kiss of the Channel Line

4.

Major Price Levels

5.

Determining Balance Of Power

6.

Doing the Math - Setting Stops and Calculating the Waves

7.

Multiple Time Frames

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II. Putting It All Together

59

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True Support and Resistance

]0. Trading Options

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8. The Repeating Channel and Trend Angle
9.

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VlI

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43

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85

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181

Introduction
Trading is a blessing and a curse. It is a blessing in that no other occupation
can be more exciting and rewarding than trading. You literally can become
a mill ionaire overnight or at least in a very short period of time. On the other
hand, trading is a curse because it is more likely that you will make someone
else rich long before you have any real success. It is without a doubt the most
expensive education you can obtain. In the process of educating yourself
it can destroy your marriage, your retirement, your home ownership and
many other things that take a lifetime to acquire. Poor money management,
inability to control one's emotions and a clueless approach to trading leads
many down the road to the poor house paved in fool's gold. It may look great
to walk on, but who really wants to go there?
My own introduction to this blessing and curse came from a man in a
cowboy hat that made trading sound like child's play. Very quickly I
realized that I was in over my head and that this man probably would
have sold me the Brooklyn Bridge if given half a chance. Since then I
have hit rock bottom twice while trading. (A nice way of saying I lost it
all) After my last fiasco, I decided since I couldn't find any method that
worked to my satisfaction, that is a method that actually made money,
I would discover one for myself. This lead to a number of observations
and discoveries of how the market works, why it behaves the way it does
and more importantly, several methods that actually work that are based
on the geometry of the market. Channel Surfing is one of those methods,
providing an in-depth understanding of the markets that you will rarely
find elsewhere.
As you read this book you can expect to learn the following:
The basic concepts of Channel Surfing, presented i n a way

that is easy to understand and easy to apply.
2. Why channels are a natural phenomenon and how to take full
advantage of this.
3. How to take the basic concepts of Channel Surfing and
catapult it into an even more powerful method of trading
using advanced techniques.
4. Additional tricks to reading the geometry of the market that
add to your success.
1.

IX


While there exists an endless array of indicators available to use in
this day and age, most have one common fail ing; they fail to adapt to
changing market conditions. Channel Surfing succeeds in adapting to
market conditions because channels are actually weaved by the market
itself. Price rarely moves in a straight line, therefore channels provide the
ultimate momentum indicator.
Despite its adaptability, Channel Surfing continues to outperform many of
the most popular indicators in use today, time and time again. The beauty
of it is that it doesn't require you to suffer through large drawdowns in
order to realize a profit. I n fact, it is so effective that it is probably the very
best approach for beginning traders and those with very little capital. So
just imagine what an experienced and well-funded trader can do with it!
Although a parallel is made with actual surfing, this is a methodology
that is about something very serious, trading profitably. But obviously the
more success you have and the greater your confidence in your ability to
extract a profit, the more pleasurable it becomes. Success and confidence
are directly influenced by your ability to understand the market that you

are trading. To that end each chapter of this book will take you step by
step through the process of reading the language of the markets. Put into
practice an individual can look at a market and recognize how it is likely
to behave and react to the various situations that arise, a skill that often
takes decades for a person to develop.
Chapter one begins by covering the basic concepts of Channel Surfing,
with nineteen illustrations that make it easy to comprehend. Five different
entry methods are covered, along with two exits. These basic concepts
alone can dramatically improve a person's trading success, but this is only
the begi oning.
Chapter two describes several specific entry methods that enhance the
basics and provides more opportunities to enter a market with low risk.
Chapter three delves into an important price phenomenon that can be
exploited for profit. It also takes a closer look at the psychological aspects
of trading and how they impact success.
Chapter four examines major price levels, which include much more
than just support and resistance. M ajor Price levels impact how trading
decisions are made and can even contradict normal guidelines, so they are
discussed in detail.

x


In chapter five the balance of power is discussed. What is the secret to
knowing the bias of a market? The answer is detailed here from the most
subtle indications on up to the larger and stronger signals.
The math of Channel Surfing is covered in chapter six. Calculations are
a requirement if you want to provide specific entry and exit numbers to a
broker, but they also provide several other advantages as welL.
Chapter sevcn elevates Channel Surfing to another level by using multiple

time frames as a basis for trading decisions. This one technique will
dramatically increase the odds of success in any trade you consider.
Chapter eight brings a series of additional techniques to the table that
enhances trading even further. Simple and effective, they provide
additional tools to your trading arsenal that will cut down to size any
market that is stubborn ly refusing to be analyzed.
Chapter ninc is a real eyc opener and after reading it you will never look
at a chart the same way again. True support and resistance flies in the face
of traditional technical analysis, but it has proven itself time after time.
Practically every consolidation pattern, reversal and acceleration can be
understood and even predicted by using this invaluable method of reading
a market.
In chapter ten options are discussed. Options offer a great opportunity for
profit if you can accurately identify where a market will go and when it
will be therc. How to determine these key factors are outl ined.
Chapter eleven brings everything together providing several trading
examples that show how to effectively use these methods. A sobering look
at the reality of trading is discussed, as well as some additional factors that
will impact trading success.
The techniques and methods discussed in this book provide a complete
trading plan that improves as the skill of the user improves. More than
what is needed is discussed so that an individual can adopt what fits their
particular style of trading. But initial ly the most conservative techniques
should be utilized. For example, some entries described in this book can
be very aggressive and have been identified as such. While such high-risk
entries are at times discussed, several that are low-risk are emphasized
throughout this entire book that will provide plenty of profitable trades
without the need of such aggressive tactics. So initially focusing on the
conservative techniques is strongly encouraged.
Xl

Channel Surfing is a solid foundation for understanding the language
of the markets. Even though my research has led to other advanced and
powerful trading techniques, I still return to Channel Surfing whenever
I first look at a chart. I am convinced that it will become your first and
favorite choice when you look at a chart as well. For all its simplicity it
remains an exceptionally powerful technique because it keeps losses low
and profits high. I wouldn't trade without it.
Besides, what could be more fun than surfing? Especially when it is
profitable!

Xli


Chapter One

Channel Surfing - The Basic Concept
A surfer surfing a wave, a sailboat sai ling with the wind and a glider
soaring an updraft all have one thing in common. They catch and ride
natural forces in motion. Yet, a surfer has no more control over a wave
than a sailboat can direct the wind. They simply take advantage of forces
that already exist for their benefit.
It is no different for a trader. During the course of a long and successful
career in trading an individual will weather many storms and lulls in the
markets and face many updrafts and down drafts. No one can dictate how
the market will act, but that doesn't mean that we can't learn how to take
advantage of the forces that develop.
Have you ever seen what a surfer does when a storm brews? As a storm
hits a coastal area most beachcombers wil l avoid the beach. But a surfer

sees this as an opportunity and they will come out in droves l ike sharks
circling bait in hope of surfing larger and better waves. In a sense, trading
is the same because a market storm can result in some wild swings and
potential ly offer an exceptional ly high return. For an inexperienced surfer,
such a storm could mean a wipe�)Ut just as surely as a stormy market often
does for an inexperienced trader. In contrast, a storm for an experienced
surfer can mean the ride of his life, just as a wild market can mean a
windfall for an experienced trader.
In many ways the market behaves just like the waves of an ocean, so
forming a parallel between a surfer and a trader is as natural as a wave
breaking along a beach. The similarities between surfers and traders are


Michael 1. Parsons

uncanny. A surfer will wait until he finds the best wave, time his entry,
ride that wave as long as he can balance on it and then go back out to
catch another wave. Guess what a successfu l trader does? He waits for
and chooses the best market, times his entry, rides that market as far as
he can manage and when the ride is over he starts the whole process all
over agam.
Throughout this book you find many references to the simi larities that
exist between surfing and trading. But in all seriousness this book is about
a trading method that actually works and has proven to be one of the
easiest to learn, easiest to apply and easiest to fol low. Particularly if you
are a beginning trader or have a very limited budget you will appreciate
how this method overcomes your limitations by providing you with low
risk and high return. The analogy to surfing serves to give you a visual
aid to understanding what it takes to be successful in trading. But where
a surfer surfs the waves strictly for fun, you will be surfing the market for

both fun and profit.
So how do you surf the markets? Visualize for a moment a surfer surfing
a wave. He rides a flat board that he balances on the cascade of a breaking
wave. I nitially, he sets up where waves first break at what is known as the
impact zone and makes a wave (catches a ride), and balances for as long
as he can until the wave finally collapses on itself just shy of the beach.
Once the wave dies and slips away from under the surfboard, the ride is
over and its time to set up for the next wave.
Channel lines act as your surfboard and price your wave. As long as your
surfboard rides the price wave, then you just have to keep your balance
and enjoy the ride. When price slips away from your channels then the
ride is over and it is time to set up for your next wave.
In other words, Channel Surfing uses channels to set the parameters for
price movement. For those of us that are mathematically impaired, this is
a graphical way to determine what the market can be expected to do and
not do. The value of this is that if it exceeds these parameters then you are
alerted to a change in a market's condition and the need to make a change
in your trading.
Here is how it works: Once a market is moving, you draw a trend line
fol lowing the edges ofthe price bars using the highs or lows as your gauge.
Normally, you will need to have at least two highs or two lows to draw
your l ine from and the more highs or lows to work with, the better. But it
2


Channel Surfing

is not a matter ofjust finding the most bars, but rather the bars that outl ine
the extreme of price activity. So there may only be a few bars to work
with, particularly when a trend is new. However, as a rule the greater the

number of bars that support a trend l ine, the stronger these l ines will be.
On the other side of the price movement you also draw a simi lar trend
li ne and thereby, create a channel . In effect, you put a fence around
the price movement and provide a visual range parameter. Each price
bar that fol lows should be within that channel and whenever you see
a price bar exceed one of those channel l i nes then you know it is time
to take action.
The highs and lows you draw to create a channel should enclose all the price
movement, so you are looking for the extreme highs and lows that fol low
a singular direction. For the length of this book I will be differentiating
between these two l ines by referring to them as an outside l ine or inside
line. By definition, the inside line is the channel line that is always to your
right, whether the trend is up or down. The outside line is the channel
line that is always to your left. So if you have an up trend, the inside line
is the supporting line, while the outside line is the resistance line. In a
downtrend, the roles are reversed and the inside line is now resistance
whi le the outside l ine is support.
Notice in Figure 1 - 1 how the channel is drawn and that there is an inside
and outside line that will reverse roles depending on whether you are in a
bull or bear market (up trend or down trend)

The extreme swings of a trend
are used to define a channel

3


Michael 1. Parsons

What if the market happens to be i n a sideways pattern? The principles

are the same with one exception; channel l ines are drawn horizontally
rather than diagonally. When the channel lines are horizontal there isn't
any inside or outside l ines. So i n this case the channel lines are simply
referred to as the upper and lower channel l ine. Figure 1 -2 demonstrates
how this is done.

Lower Channel Line

QQQ 1 Minute

Exiting with channels

So now that we have a basic concept as to how to draw our channel, how
do we use it?
Success in trading depends on putting the odds i n our favor. By this I mean
that we want the odds favoring that the market will go in the direction of
our trade. But we also want the odds favoring profit over loss; that is we
want our losses to be small and our profits h igh. As in any game you might
play success in trading isn't about making all the points but winning more
points than you lose, or in real life terms, winning more dollars than you
lose. Putting the odds in your favor is not a matter of luck, but a matter of
evaluating the risks, determining what the odds favor and then taking the
position that is favored to win.
The channel is our guide for evaluating our risk, a basis for making our
trading decisions and for weighing the odds of any trade. As long as price
remains within a channel and moving our way, then the odds are in our
4


Channel Surfing

favor. But as soon as price extends outside a channel the situation has
changed and so have the odds. It is now time to exit. Exiting is a key
component of Channel Surfing and it happens to also be a key component
of successful trading.
Initially, most traders want to focus on their entries, thinking that if they
enter well then they are bound to make a profit. While it is true that entries
can make a substantial impact on any trade the reality is that exits have
an even greater impact. An entry only deals with one thing in your trade,
the starting point. But exits incorporate two elements, the avoidance of
unnecessary losses and the locking in of profits.
Just consider one exit fault that can sabotage your success; exiti ng too
soon. I f you exit too early such as just before a market starts to move
in your favor, then it doesn't matter how great of an entry you make
because you stiII take a loss. I n l i ke manner, if you exit before a trend
has a chance to finish its run then you miss out on a large part of the
profits. A bad entry can mean a small loss, but a bad exit can mean a
financial disaster.
So if exits arc one of the most important aspects of trading then it is
essential that we understand how to determine our exits properly and
when to exit. So for the next few moments we will be examining how
Channel Surfing determines exits.
Trends tend to offer some of the best tradi ng opportunities in trading, so
we will look at one in our first example. I magine that you have shorted
or sold a market that is in a downward trend. The trend has established a
wel l formed channel that the market is fol lowing perfectly. Suddenly the
market slows down and extends through the inside channel Line and price
bars start to close beyond it, breaking the channel. When this happens the
first rule of Channel Surfing is to get out as soon as possible because this
signals that the market has changed and likely will extend into a sideways

pattern or possibly reverse direction entirely.
Take a look at Figure 1 -3. In this chart example I have entered a trade
by shorting (selling) a contract at the point it breaks a support l ine. As
it drops, channel lines are drawn. Later, the market extends beyond the
inside channel line and an exit is signaled.

5


A4ichael J Parsons

An exit is signaled when the
market breaks out of the channel
- Its time to lock in the profits!

A short is taken when the market
breaks an inside channel line and holds

Hewlett Packard

The signal is relatively simple, break the l ine and you exit. To clarify
this a l ittle, you are looking for an actual break and not j ust a touching
of the line. Price is expected to have contact with the line, but an actual
break where price extends beyond it is another story. This is particu larly
true if price not only breaks the l i ne, but price bars actually close
beyond it.
But in Channel Surfing we use two l ines, not just one. So what if price
exceeds the opposite line? The answer again is to exit. Even though it may
look like the market is accelerating in your favor, when this line is broken
it usually develops into a reversal. So despite the apparent good fortune,

an exit is still called for.
Notice Figure 1-4 and what happens.
Odds are that by exiting when a channel line is exceeded you are locking
in the highest amount of profit. This is particularly true when an outside
l ine is broken because an accelerated move usually ends in a spike before
reversing direction. This phenomenon occurs because price hits a critical
level and the market over-extends itself. For many unskil led traders this
is a temptation they can't resist, a move that appears to be rocketing out
of control. Only they are in for a surprise because a rocket out of control
usually comes crashing down to the ground. By over-extending itself a
market has in essence doomed itself to col lapse.

6


Channel Surfing
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A re-entry can be made as a smaller channel

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An exit i s also signaled when the market
breaks through the outside channel
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Since we are using two channel lines that require an exit if broken, then
two stop orders would be needed instead of just the usually one stop limit.
Additional ly, should either exit order be activated, the remaining order
would then need to be cancel led at the same time. Such requirements in
your orders can be placed with a broker, but might be diffic ult with some
on-line order systems. But aside from these additional requirements, the
method is relatively simply to apply. Stop l imit orders are placed just
outside, but close to the channel l ines. They cannot be equal to them
because the market is expected to actually reach them and you would be
forced out of the market needlessly.
I f you are trading daily charts and are able to watch the markets during
the day, then do not exit immediately when an outside channel line is
broken. The reason is that a break of an outside channel l ine often leads to

a price spike and a market will tend to move some distance before actually
reversing direction. So sometimes it works to your advantage to wait a
little longer while it extends as far as it will go before exiting your position
and thereby capture more profit. Simply establ ish a new channel line at the
accelerated rate and fol low price until this new and tighter channel line is
broken.
Whether you diligently watch the markets through the day, set a stop
based on a recent high or low, adjust your stop at different intervals as
the day progresses, or simply have an alert that notifies you when price
exceeds a parameter, the idea is to take advantage of the continued move
7


Michael 1. Parsons

fol lowing a channel break until the trend falters. But even if you take the
easy way out and place a stop j ust outside the two channel l ines, the key is
to keep oneself protected from any undue risk. Just make sure your broker
u nderstands that if one order is fi l led that in turn, the other is canceled or
you will end up entering a market unexpectedly. There are times when
"flipping" your position may be something you would want to do, but
usually this is inadvisable.
From an emotionally standpoint, exiting out of a market when it appears
to be rocketing in your favor is a l ittle hard to accept. After all, the market
is accelerating and most traders would think that this is very positive, not
something negative. So why would you want to exit at this point? Won't
you miss a lot of profit?
There are times when you will miss a profit, but look at this realistically;
what usually happens when price exceeds the outside channel? Usually it
turns around and reverses direction. I f you tried to hold onto your position

in the hope that it will continue accelerating, then you will most likely
lose a portion of that profit. The loss will frequently exceed any profit you
might have gotten by chasing after the market. So unless you are able to
closely monitor the move as it is developing, it is best to leave it alone and
gracefu l ly bow out. There is an exception to this rule that we will cover
much later, but for now the rule is: Exit whenever a channel line is broken,
plain and simple.
A word of caution is in order here. When a strong trending market exceeds
the outside channel it is a sign for exiting your position, not reversing it. I f
the market should continue and gap the result could b e a substantial loss.
Discretion is the better part of valor here.
When a trend initially begins and the first line of support or resistance
establishes itself there will be a question as to where to draw an outside
channel line, which is used to determine the limit of how far the market
is expected to travel. As this point, simply create a line that is at the same
angle as your first channel line and place this on the solitary high or low
that currently exists on the opposing side. I f you have a charting program
that allows it, just duplicate the l ine and move it into place.
As a trend develops, channel l ines tend to run parallel to one another and
so either l ine can be used to as a gauge for the other. This enables you
to establish the channel parameters very quickly and later on you can
adjust it as necessary to the actual market when the trend becomes fully
8


Channel Surfing

established. Often there will be a slight variation, but as a rule they will
generally be very close in angle to one another, if not exactly the same.
The exception is ifthere is an imbalance of power, which will be discussed

in a later chapter.
In Figure 1 -5, the channel line created by the supporting trend line is
dupl icated and then moved with the same exact angle to new high. This
completes the channel and provides a starting point to work with. As
other highs are established an adjustment of the channel line can be made
accordingly.

Resulting i n an
exit near the top

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Because this is only an estimated and temporary channel line rather than an
actual one, there will be a need to allow some leeway as price approaches
it. Price may either fai l to reach it or actually exceed it by a small amount.
In either case, price should draw close to the estimated l ine. If not, then it
could indicate a problem with any trend development. Additionally, while
the line may be broken there should be no substantial move beyond it and
any break should only be short-term. Any excessive break or delay in
reversing would indicate that your parameters are off. Fortunately, you
usually do not have to wait long before you know exactly where a market
permanently sets the outside line. From a trading standpoint, the advantage
of having an estimated channel l ine is that you know approximately how
far price should move. When price backs away after reaching this l ine it
wi ll not come as a surprise and create a panic. But there are other reasons
for using an estimated channel l ine.

9


Michael J. Parsons

I f price fails to reach this level it would be an early sign that the trend
is too weak, giving you an opportunity to exit before it falls back into
a losing position. Additionally it can help you to avoid excessive draw
down and open up the opportunity to profit twice, taking advantage of
multiple moves covering the same territory. I f the distance between the
two channel lines is great enough, then it may be more profitable to exit
near the opposing channel line (even if it is an estimated one) and reenter
when price comes back to your original channel l ine.
Because Channel Surfing is so flexible, you can adapt it to all markets,
time frames, and market conditions. Figure 1-6 demonstrates how
Channel Surfing can be adjusted for a market that is accelerating. This is
an important aspect of Channel Surfing because it allows you to always be
one step ahead of the market.

Inside c:hannel lines narrow as a
market accelerates, tightening your
stops and protect your profits
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Initially, a trend can develop a wide channel that narrows down as it
accelerates. This acceleration will draw price away from the inside line,
diminishing the value of that l ine. This in turn will require an adjustment
of the inside line to match the new parameters, even ifprice shows no signs

of altering the outside line. An adjustment is made by drawing a new line
to replace the outdated one. So as a market narrows, you in turn narrow
down your channel line to match it and repeat this as often as necessary.
Because trends have a habit of repeating this process several times before
the trend actually ends, you frequently end up with a fan l ike pattern. The
adjustment of a channel l ine is a one-way affair that continually tightens
yoUl stops as the market accelerates. Each new fan line becomes the only
10


Channel Surfing

inside channel line you are concerned with because as soon as the tightest
angle is violated, you exit. Handling market acceleration this way allows
you to closely monitor your trading and protect your profits.
To summarize what we have covered so far; two l ines are drawn to enclose
price activity and when price violates either of these l ines you exit your
trade. In market acceleration, draw additional new channel lines that form
a fan pattern and exit when the tightest of these lines is violated.
These rules for exiting will help you to trade more successfully. But for
these rules to be of any value, we sti l l need a way to enter a market in the
first place. So this is the next area that we will consider.

Entries using channels

Because a wide variety of market conditions can arise, there is in turn a
wide variation of entries that can be chosen. The approach you take will
depend to a large degree on your risk tolerance. So one determining factor
is how aggressive or conservative of a trader you happen to be. Aggressive
trading would be viewed as trading with greater risk in the hope of more

robust profits, whi le conservative trading would be viewed as exposing
yourself to much less risk, but in turn, accepting lower profits. Despite
the impl ications, don't automatically assume that aggressive trading is
always more profitable or that conservative trading always has less risk.
The approach one takes should be based on the conditions of the market
that is he or she is trading just as much as one's own trading style and risk
tolerance.
So the first step is to evaluate whether or not the risk is acceptable to
you. This leads to an important question that needs to be answered before
entering into any trade; what is the potential return as compared to the
risk? This is known as the risk/reward ratio and is a simple mathematical
calculation where you divide the potential reward by the potential risk.
Ideal ly, you would want a ratio of four to one. In other words, a trade
should have a potential profit that is four times greater than the risk that is
being taken. Now at this juncture you may be asking, how am I supposed
to know what the potential profit will be? Don't worry; you don't have
to be a psychic here. We are not talking about predicting the future, just
estimating the potential move.

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Michael 1. Parsons

There are two factors to determine here. First, you are determining where
you would exit or place your stop. The difference between this figure and
your entry is the risk of your trade. Second, you are determining the likely
move of the market and the difference between this and your entry provide
your potential reward. This last figure is based on a market's previous
action, any channels that develop, and the current trend. Support and

resistance levels and recent swings provide a gauge of previous market
activity. A larger channel than you are currently trading provides a gauge
of possible price movement and this will be covered in more detail later.
Additionally, channels provide key information about potential trends and
what can be expected. For example, an up trend that has an average move
of ten points each day and today happens to have an expected range from
100 to 110. If we are able to enter below 102 and thereby only risk two
points while having the remaining potential of an 8 point move, then you
would have met the criteria of an acceptable risk/reward ratio.
Why would determining a risk/reward ratio be critical? There are two
important reasons why, money management and controlling the emotional
aspects of trading. These two also happen to be top of the list for destroying
trading success. For example, often a trader will attempt to jump into
a market when it appears to be building momentum and speed. But
commonly this is exactly where a trend will come to an end and reverse
direction. But because the trader entered so far beyond any stop that he
will set, he has to allow a greater amount of risk and when wrong, accept
a much greater loss.
Even ifthe market goes your way you can still lose money if the risk/reward
isn't reasonable. Slippage alone can eat away at your profit. Imagine the
frustration you would have if you tried to buy at 1000 and actually get filled
at 1002 and then turned around to sell at 1003 only to be filled at 1001.5.
You may have been right about the market and what it would do, but you
still lost money because of slippage. Breaking even on a trade is still a loss
because you have to pay your broker. Remember that you are trading to
make yourself rich, not your broker. Determining your risk/reward ratio
helps to put the money in your pocket rather than someone else.
The first approach to determining the risk/reward ratio is to simply
calculate the trend average and find an entry that is on the favorable side
of the trend. What this means is that for you to enter on a four to one ratio

you would need to enter within the best quarter of that range. Subtract
the low from the high of a channel to determine a trend average and then
divide this number by four. Add to or subtract from your inside channel
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Channel Surfing

line and you know the ideal zone to enter. Ideal is not always practical
and there will be times when a trend will not cooperate with this ratio of
entry, such as during times of a trend acceleration. In such cases you may
have to accept a greater risk, perhaps attempting to enter when you have
a two to one ratio. Even though this may be required from time to time,
most trends will work with a four to one ratio and an adjustment will not
be necessary. Don't allow a trend that is simply uncooperative for a few
days allow you to fal l into the bad habit of chasing a market. I n any event
and regardless of the trade situation, you should always have a greater
potential reward than any risk. If you have an equal risk/reward ratio then
it is no better than just flipping a coin.
Once you have an acceptable risk/reward ratio, the next step is to enter.
There are five specific entries that we will be focusing on in this chapter.
There is an aggressive and conservative entry, each with its own specific
rules. Additionally, there is an inside entry that borrows from both of
these entries. Finally, there arc two other entries called the rebound entry
(sometimes referred as the "kiss entry" for short) and the trend entry,
which is used for entering after a trend has been established. Initial ly, the
focus should be on the conservative entry and the last two entries (kiss
and trend entries) because they provide the least amount of risk. So these
three entries should be learned first, even though two are actual ly l isted
last. In the fol lowing chapter some additional entries will be expanded on

that are designed to adapt to breakout situations that frequently arise.

Conservative Entry

The rule for a conservative entry is as follows:
Enter when an inside channel l ine is broken and price bars close
beyond that line.
Waiting for price to close beyond a channel l ine ensures that a break isn't
just a rogue spike. Further, it usually doesn't hurt to wait for multiple closes
either. A bar close is simply a term that defines where price settled in a
given time period. So the issue here is not whether or not price extended
into an area, but if it stayed there until the next time period began.
Whi le there is a risk of a market rocketing off and leaving you behind
as you wait for the confirmation of a bar close, odds are that it won't. In
fact, a market will usually pull back toward the prior channel l ine before
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Michael 1. Parsons

continuing with a new trend. I n the early stages of trend formation there is
a strong possibility that a market will give you a false signal. I f this were
the case, a premature entry would put you on the wrong side of the market.
So this is a good low-risk rule of entry.
To illustrate, if you had been in a downtrend and the inside channel line
(the one acting as resistance) was broken by price fol lowed by price bars
closing beyond that line you would then buy or enter long. In the opposite
scenario of an up trend you would then go short after the inside channel
line were broken and price bars closed beyond the line.
If the market had been in a trading range or sideways pattern and both

your channel l ines are horizontal then you would enter when either of
these l ines is broken and price closes beyond that line. Figure 1-7 provides
an example of a conservative entry.

Enter on the

Crude

all

Ckart

The previous inside channel l i ne now becomes your initially stop. So
the rule then would be that if price exceeds an inside channel line
and then returns back within the prior channel, then your trade is a
bust and you need to exit. A prior channel usual ly works wel l as a
temporary stop, but there is a problem that can sometimes arise when
using this method. The prior channel line is al ready headed in the
opposite direction of your trade and so the stop limit wil l natura l ly
increase with time, increasing risk right along with it. Obviously
then, an additional limit on your trade is needed. If a new channel has

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