Channel-based technical analysis trading strategy used as an indicator for trading in financial markets
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Donchian Channels are a channel-based technical analysis trading strategy used as an indicator for trading in financial markets. The indicator is primarily used by traders to identify potential breakouts and retracements. A breakout is a rise in a security’s price above a resistance level (previous high) or a drop below a level of support (previous low).
On the other hand, a retracement is when the price of a security starts to move back towards its previous price after a significant change – e.g., when a stock falls by 15% and recovers by 12%.
Richard Donchian, a successful American futures and commodities trader, developed the Donchian Channels. He was a pioneer in managed futures, establishing the first futures fund named Futures Inc. in 1949. He also aided the model for mutual funds in the U.S.
The turtle trading system was established based on his work. Richard Donchian developed a moving channel trading strategy in the early 1970s, which was named after him – the Donchian Channel.
The Donchian Channel indicator makes use of candlestick charts, as data is clearly shown and mapped, which helps in decision-making according to signals detected.
The candlestick chart shows stock performance over a given period where each sub-period – i.e., trading day, week, or hour – is represented by a candlestick with a shadow showing upper ‘high’ and lower ‘low’ for the period.
The candlestick is white on a day where price increases and black where the price declines. The bottom of the white candle shows the opening price, the top shows the closing price, and the opposite is true for a black candle.
The candlestick chart in the Donchian Channel shows vital information for decision-making in a trading session. The channel is made up of an upper and lower band and an average in the middle. The illustration above shows a Donchian Channel.
Donchian Channels are a trend trading indicator using current price momentum for decision-making.
The upper band is calculated as the highest price reached in the prior period, and the lower band is calculated as the lowest price reached in the prior period.
The middle line is the average of the lower and upper bands.
Mechanics of the Donchian Channel
The Donchian Channel uses three bands in which the upper band shows the highest price of the previous period, and the lower band shows the lowest price of the previous period. The middle line shows the average of the two prices.
The three bands show the current market momentum in a stock or financial instrument and enable traders to take a market position to profit from an expected rise or fall in value given indicative signals.
If the market is trading towards the upper band, it may signal a bullish trend, which indicates a long position on a financial instrument or the market as a whole. The opposite is also true if the market trend is moving towards the lower band, indicating a bearish trend – it is a signal for making a short position.
However, if prices are trading in the middle line, it may indicate low volatility in the market, and a hold strategy may be employed pending further signals.
Calculation of Donchian Channel Parameters
The calculation of Donchian Channels involves a separate calculation of the upper band, lower band, and the average middle line.
The calculation is as follows:
Upper band: Highest price in prior n periods
Lower band: Lowest price in prior n periods
Middle line: (Upper band – Lower band)/2
n can be a different period length depending on the measurement time frame under study – such as minutes, hours, days, weeks, or months – and the period will be the number of periods being measured (e.g., 30 minutes, 24 hours, 20 days, 1 week, or 6 months).
Typical Donchian Channels use a 20-day trading period, which is the average number of trading days in a month.
Trading Mechanics for Donchian Channels
There are two main approaches used on Donchian Channels – one concerning a possible bullish trend and another concerning a possible bearish trend. Traders use the middle line to separate these two approaches.
The Donchian Channel is a standard illustration of a trading strategy, where a trader should always be present in the market and always looking for ways to get out.
The Donchian Channels strategy is a market volatility indicator; if price movements are small indicating low volatility, the channel will be relatively narrow. However, in periods of high volatility where price fluctuates excessively, the channel will be relatively wide.
If the price of a security goes above the middle line, this is a signal for traders to make a long position, as it indicates a bullish trend. Traders will maintain a long position to see if the price reaches the upper band.
If the price does hit the upper band but does not break through it, traders will most likely close their long positions and open short positions, expecting the price to decrease towards the middle line. However, if the price breaks through the upper band, it signals a continued bullish trend, and traders will maintain their long positions.
The breaking through is known as “breakout.” To safeguard against trading a false breakout, traders usually require that the price closes consistently above the upper band for a given or defined timeframe.
The trading convention makes use of stop orders, such as guaranteed stops, to protect against a bearish trend reversal on this approach.
Short positions are opened if the price of a security drops below the middle line. Traders will hold their positions until the price hits the lower band. If the price reaches the lower band but does not breach it, traders will normally close their short positions and open long positions on the security in anticipation of a bullish trend towards the middle line.
However, if the price breaks through the lower band and consistently closes below the lower band for a given timeframe, traders will maintain their short positions in expectation of a continued bearish trend. Stop orders are also employed to protect against a bullish trend while traders are holding short positions.
Trading Strategies for Donchian Channel
Here are two effective strategies that are mostly used by traders – i.e., breakout trading and reversal trading strategies.
Breakout Trading Strategy
This is a short to medium-term strategy in which a trader enters a chosen trend as early as possible with the expectation that the security price will break through the upper or lower band, i.e., a breakout from its current trading range through a sustainable bullish or bearish trend, respectively.
Reversal Trading Strategy
In this strategy, a trader will wait for a reversal trend to occur from the current trend before taking a long or short position, depending on the reversal trend.
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