How Donchian Channels work

by Tom Black
How Donchian Channels work

What is Donchian Channels?

Donchian Channels refer to three lines that are generated by moving average calculations. These include an indicator that is formed by the upper & lower bands just around a median band or a mid-range band. The upper band denotes the highest price of specific security over ‘N’ periods. The lower band denotes the lowest price of specific security over ‘N’ periods. The middle band calculates the average between the lowest low over the specific period and the highest high of the period. Thus, it identifies a mean or a median reversion price.

Donchian Channels aim to identify bullish & bearish extremes which favor breakouts and reversals, breakdowns as well as emerging trends, lower and higher. It is a comparative relationship between trading ranges and current prices over a certain period. These three values create a visual price map over time, quite like Bollinger Bands, thereby indicating the bearishness and bullishness for the selected period.

Donchian Channels are one of the most versatile, yet quite a simple tool available. These are easily applicable to different chart types as well. The period is easily adjustable considering the unique features of each market. A unique feature is that the application to a live market is intuitive.

Donchian Channels

History of Donchian Channels

Donchian Channels were developed by Richard Donchian who is a famous trader, fund manager, and writer. Traders can consider Donchian Channels along with any other financial product that is prevalent in the equities market, futures, and currency. Richard Donchian is also known as ‘Father of Trend Following’ is widely acclaimed for being the pioneer in the money management industry. In 1949, he created the 1st managed fund. He devised a totally new technical approach in trading decisions. His strategies are market-based, and price action is the foundation of them. 

The calculation is based on a specific period, denoted as ‘N’. Originally, the ‘N’ period was based on daily values. However, in the current scenario and on today’s platforms, the investor usually determines the ‘time’ which does not necessarily include the daily values. This can be ticks, minutes, hours, or days. Donchian Channels are now available on major trading platforms and is widely used by traders.

How Donchian Channels can be adjusted?

Traders use Donchian Channels to find out breakouts, volatility, and potential oversold/overbought conditions for any security. It uses adjustable bands that are set equal to the highest highs and lowest lows of the n-period across a moving average. When using in combination with other technical indicators the Donchian channel’s upper and lower bounds can form effective support and resistance levels as well. 

Systems that are based on Donchian channels use either a four or a five-week moving average line. Traders conducting Donchian channel analysis have to wait to spot the point at which an asset’s price breaks through the lower or upper band. It is at this point they have to enter into a short or long position. For instance, most traders go long, covering their short positions when the price exceeds the high point of the four previous weeks. 

Traders can also use Donchian channels for crossover strategies, in combination with another moving average indicator. In such situations, the moving average middle line is likely to form a short-term average. There are some traders however, who use a 20-day Donchian channel with a five or a ten-day channel for exiting a position before short-term profits get affected by consolidation. 

Because Donchian channels appear to be so simple, there is a danger of incorporating them into a trading strategy.  Even though it provides a great way to spot breakouts from the lower and upper bounds, these events are uninformative. This is because Donchian channels do not provide new information, rather only allow the trader to visualize obtainable price data. For instance, a breakout may trigger a possible reversal or be an indication of the start of a long-term trend.  Traders should use them as confirmation tools combined with other tools of analysis. 

Basic Strategies Using Donchian Channel

On a chart, the Donchian channel becomes narrow when the prices are stable and wider when there are heavy price fluctuations. Apart from trading the trend, traders also have to rely on volatility to generate profitability. Thus it depends on the traders on how he/she might use the information to implement in strategies. 

Let us take the recent period as X. If the price of an asset decreases below the most recent x period value, traders can interpret it as a sell signal. On the contrary, when the Donchian channel breaks above the most recent x period high, traders can interpret it as a “buy” trade. 

The Donchian channel is helpful for identifying some of the characteristics of price action. They are as follows: 

  • Overbought: An overbought condition is when the price approaches the upper band of the Donchian channel. 
  • Oversold: An Oversold condition occurs when the price approaches the lower band of the Donchian channel
  • Trend: Sometimes the prices can stay constantly in an oversold or overbought area. This can either be a signal for the price getting stronger or act as a confirmation of the trend. 
  • Breakout: When the market is moving in a range or is in a “dead” market condition, it indicates that an upcoming breakout is imminent. 

Traders can thus, use the Donchian Channel indicator to enter or exit their trades if the market is experiencing any of the above states and scenarios. 

Donchian Trading Strategy to Ride enormous trends

The Donchian Channel strategy helps a trader to ride a massive trend in the market. This means, trailing their stop loss. In other words, Traders cannot have any target profits, cannot second guess, and bailout during uncomfortable moments. Traders have to get out only when the signal tells them to.
Traders can ride big trends by following any one method. 

    • They can use the upper band or 20-day high to trail their stop loss if they want to ride an uptrend.
    • They can use the lower band or 20-day low to trail their stop loss if they want to ride a downtrend. 

Donchian Trading Strategy to Ride enormous trends

Traders should simply adjust the Donchian Channel settings to ride shorter or longer-term trends according to their preference. 

The Bottom Line

Donchian Channels are a powerful but simple analytical tool. It is a technical indicator that measures the relative volatility of any financial instrument, with its primary function rooted in trend identification. This is why it is applicable to currency, futures, equities, and more. Traders can use this indicator, along with other technical indicators or with other market fundamentals. It is helpful in determining active trade management and market entry.

Markets are dependent on different cycles of activity. Donchian Channels use an arbitrary ‘N’ period value which might not always reflect the existing market conditions in the right way. It tends to generate false signals which undermine investment and trading performance. Thus, traders can utilize this indicator before key decisions.

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