CHANNEL LINES AND THE BIOTECH ($BTK) INDEX

A closely associated concept to the trendline is the channel or return line.

The trendline is a primary tool of technical analysis and the channel line a secondary one. Many times, when I view the work of other technical analysts I admire their insights, but question their drawing of channel lines. Sometimes they are inserted where I believe they do not belong. When constructing a channel line, it should be drawn absolutely parallel to the basic trendline or at minimum very close to parallel. A channel line sloping at one angle, while the trendline is sloping at another, is not correct and can lead to misleading conclusions.

When drawn correctly, the channel or return line represents the point at which reactions start against the current trend. The trendline and the channel line together define the area called the trend channel or simply the channel. In a downtrend, the reaction low created at the return line is a form of support. The failure to reach a channel line provides warning that the current trend is losing strength. If, on the other hand, a stock breaks out of the channel line, it is a sign the current trend is accelerating.

An index I focused on as showing important technical weakness in last week’s newsletter is the Biotech Index ($BTK, 463.79). The channel line helps to better understand the technical behavior of the index. Let’s see how.

The Biotech index hit a high just above 565 in early March, a peak coincident with many market averages including the S&P 500 (point 1). The Biotech Index the retreated to round number support at 500 in late March (2). A rally in early April hit resistance just below the March peak at 567 (3). The $BTK then pulled back (4) and hit a new high in late April 2004 (5). Despite the nominal new high, the formation can be interpreted as a double top formation. From there, the $BTK declined to near the 490 level in mid-May (6). This was the first important technical breakdown in the $BTK because point 6 was slightly below point 4. The two reactions lows, point 4 and 6, give the ability to draw a channel line parallel to the trendline. 

Like most of the market, the $BTK went sideways for much of May. Note how in early June it hit a resistance level at 525 (point 7). The BTK again sold off to a mid-June low at 484 (point 8). This ability to hold above the channel line showed technical strength and implied that a rally was imminent even though the low at point 8 was marginally lower than point 4! 

When the rally came, it broke the downtrend line created by connecting points 2 and 8. Like the rally in the Nasdaq itself, this move was a false breakout. It again failed at resistance at 525 (point 9). In mid-July it declined to just above 484 (10), rallied to 500 (11) and then fell. Last week, when I analyzed it in the weekly newsletter, the $BTK was just a point above important support at 484. The strong potential for a break in key support was what lead me to recommend shorting Market Biosciences (MATK, $46.57) and to highlight Neurocrine Biosciences (NBIX, $44.70) as a short candidate. 

The bottom channel line (point 12) is now at approximately 435. On Thursday, the $BTK hit a new low of 454, but then bounced strongly, rallying all the way back to 475 before closing near 472. On Friday it closed at 463. Two days does not a trend make. However, the $BTK’s holding -- thus far -- above the bottom channel line may imply a countertrend rally in biotech shares is possible. The first level of important resistance is the former support at 484. Above that, there is strong resistance at 500. On the other hand, if the $BTK continues to decline, I would expect the downdraft to end at the bottom channel line of 435. 

Finally, note that the $BTK, like many technology sectors, is in a stage III top and appears to be entering a stage IV decline with the 150-day moving average close to assuming a downward slope. The 50-day moving average has just gone below the 200-day, the so-called death cross.

A channel line is a secondary tool to the trendline. When drawn properly, however, it can benefit the swing trader in identifying support or resistance. It can also help you gauge whether when the trend is losing steam or accelerating. Construct channel lines effectively and they can be an important part of your technical analysis toolkit.

Good trading!

Dr. Melvin Pasternak
Editor
The StreetAuthority Swing Trader

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