Donchian Channel is a volatility indicator that helps technical analysts to identify and define price trends as well as determine the optimal entry and exit points in ranging markets. The indicator is an envelope type volatility-based technical analysis tool. It is somewhat similar to indicators such as Bollinger Bands and Keltner Channel. Donchian Channel was introduced by legendary futures trader, Richard Donchian (nicknamed ‘The Father of Trend Following Trading’) in the 1960s. The indicator provides a graphical illustration of the prevailing price volatility of the underlying asset.
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Visually, the Donchian Channel features a median band that is enclosed by an upper band and a lower band. Functionally though, Donchian Channel is quite different from other volatility-based envelopes such as Bollinger Bands. While the latter’s bands are determined by standard deviation, Donchian Channel bands are determined by the high and low prices an asset has reached over a certain period. This helps to eliminate potentially distorted information that can be caused by spiky, unsustainable price movements.
Donchian Channel Calculation
Donchian Channel has 3 lines: Upper Band, Median Band and Lower Band. They are calculated as follows:
Upper Band = The Highest High in the previous n periods
Lower Band = The Lowest Low in the previous n periods
Median Band = ((Upper Band – Lower Band))/2)
The default n is 20 periods on most platforms, but traders can choose their own setting depending on their needs. The above formula plots a 3-band indicator that will provide information on how the current prices relate to trading ranges over a predetermined period.
Reading the Donchian Channel Indicator
The Donchian Channel is designed to provide a graphical illustration of price behaviour. The upper band is used to gauge the underlying bullish energy of the price, whereas the lower band shows the underlying bearish pressure of the price. The median band is essentially a centreline, and it is used to identify when a trend can resume after a retracement, or when there is a potential trend reversal in the market. The width of the Donchian Channel displays information on the price volatility. When the envelope is narrow, it implies low volatility, while a wide envelope implies high volatility. The slope of the channel is also considered when reading the indicator. The underlying market is extremely bullish when the Donchian Channel is sloping upwards, and prices are hugging the upper band.
The opposite also applies; there is massive bearish pressure when the indicator is sloping downwards, and prices are hugging the lower band. The Donchian Channel is primarily a trend following indicator. When it is relatively flat, the upper and lower bands serve as breakout lines. If prices rise to the upper band and manage to rise above it, it would be a signal that a bullish breakout has occurred in the market. Similarly, if the prices drift towards the lower band and below, it would be a signal that a bearish breakout has occurred.
Trading Donchian Channel Signals
Here is how to effectively trade the signals generated by the Donchian Channel indicator:
- Trading Breakouts
This is the primary use of the Donchian Channel indicator. When the price touches the upper or lower bands, it simply means that the asset price is trading at its highs or lows for the last n periods. If it touches the upper band, that is a signal that a bullish breakout has occurred and traders should place buy orders. Likewise, if it touches the lower band, traders should seek to place sell orders to take advantage of a bearish breakout. However, it is important to wait for two consecutive candles to touch of the outer bands to qualify a tradable breakout.
- Trading Pullbacks
This is a strategy to pick out the most optimal entry points in a trending market. When prices are trending, the most lucrative entry point is when a pullback occurs. This is where the median band comes in. For instance, when prices are trending higher in an upward sloping Donchian Channel, the most optimal price to place a buy order is when the price bounces off the median band.
- Trading Reversals
The median band can also be used to qualify trend reversals in the market. This can help traders exit previous trades and also enter early on a new trend. For instance, if you had an active sell order when the Donchian Channel is sloping downwards, an upward breakout of the median band would be a signal to exit the trade. It will also be a signal that buy orders can now be placed, with the first price target being the upper band and beyond.
Donchian Channel Strategies
The Donchian Channel indicator provides useful price information, but it is prudent to combine it with other indicators to pick out solid trading opportunities in the market. Here is how to build a trend following system with the Donchian Channel:
- Donchian Channel and ADX
Donchian Channel is primarily a trend timing and trend following indicator. Because its bands are essentially breakout lines, it is important to combine it with an indicator like ADX (average directional index) that will help qualify whether any breakout is a solid and valid trading opportunity. Donchian Channel breakouts are only tradable if ADX is printing a value of at least 25.
- Trading Ranging Markets
Markets do not trend all the time, and there may be an opportunity to trade ranging markets occasionally. Donchian Channel bands can be used as definitive lines of support and resistance because they consider the highs and lows achieved during a certain period of time. Still, they do not show overbought or oversold conditions. Markets range during low volatility, which will be shown by a narrow Donchian Channel. To effectively trade ranging markets, traders can combine the indicator with an oscillator such as Stochastics and RSI (relative strength index) that show overbought or oversold conditions in the market. For instance, a sell order can be placed when the price is on the upper band of a narrow Donchian Channel, and the RSI indicates overbought market conditions.
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Donchian channel trading strategy main FAQs
What is a Donchian channel trading strategy?
Most traders will wait for the price of the asset to break above the channel to go long or below the channel to go short. That’s the basic trading strategy for Donchian channels. The channels can also go well with other moving average indicators in a crossover strategy. The danger of using Donchian channels as part of a trading strategy lies in their simplicity. It may be easy to spot when price breaks from the upper or lower bounds, but by themselves these events provide no useful information regarding whether a trend is starting or a reversal is imminent.
What do Donchian channels tell a trader?
A Donchian channel will give a trader the comparative relationship between the current price of an asset and the trading ranges over a period of time, typically 4-5 weeks. This gives a visual map of the changes in price over time, and can make it easier to see the degree of bullishness or bearishness in the market during the time period under study. The top line shows the amount of bullish sentiment, while the lower line shows the amount of bearish sentiment. The middle line is a median reading of sentiment over the time period and establishes a baseline.
Are there any limitations to using Donchian channels?
One of the frequently cited disadvantages to Donchian channels is that they simply show information in a visual manner without providing any reading on the current trend in the market, or providing any forecasting value. In addition, the random nature of setting the time period for the Donchian channel may not reflect the current state of the market. When that happens, the indicator is likely to deliver false signals and create poor trading performance.
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** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.