Price channels can be used to identify trend reversals or overbought/oversold levels, indicating pullbacks within a larger trend. A spike above the upper channel line shows extraordinary strength and can indicate the start of an uptrend. Conversely, a plunge below the lower channel line shows severe weakness, which could signal the start of a downtrend.
Once an uptrend has begun, chart analysts can move to a shorter time frame to identify pullbacks by oversold readings. Below the lower channel line indicates an oversold condition that may signal the end of a retracement. Similarly, price channels can identify short-term rallies in larger uptrends. A move above the upper channel line indicates an overbought situation that may signal the end of a rally.
Using price channels to measure overbought and oversold conditions can be tricky. A security may become overbought and remain overbought in a strong uptrend. Oversold and remain oversold in a strong downtrend. In a strong uptrend, prices can move above the upper channel line and remain above the upper channel line. In fact, as price continues above the upper channel, the upper channel trend line will rise. This may look technically overbought, but it is a sign of strength to remain overbought. Similarly, the Stochastic Oscillator can move above 80, which is technically overbought and stays overbought for a long period of time.