What are Donchian Channels?

What are Donchian Channels?

Donchian Channels are three lines generated by moving average calculations that comprise an indicator formed by upper and lower bands around a midrange or median band. The upper band marks the highest price of a security over N periods while the lower band marks the lowest price of a security over N periods. The area between the upper and lower bands represents the Donchian Channel.

Career futures trader Richard Donchian developed the indicator in the mid-20th century to help him identify trends. He would later be nicknamed “The Father of Trend Following.”

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.

How to Calculate Donchian Channels

Channel High

  1. Choose the time period (N minutes/hours/days/weeks/months).
  2. Compare the high print for each minute, hour, day, week, or month over that period.
  3. Choose the highest print.
  4. Plot the result.
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Channel Low

  1. Choose the time period (N minutes/hours/days/weeks/months).
  2. Compare the low print for each minute, hour, day, week, or month over that period.
  3. Choose the lowest print.
  4. Plot the result.

Center Channel

  1. Choose the time period (N minutes/hours/days/weeks/months).
  2. Compare high and low prints for each minute, hour, day, week, or month over that period.
  3. Add the lowest low print to the highest high print and divide by 2.
  4. Plot the result.

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.

What Do Donchian Channels Tell You?

Donchian Channels identify comparative relationships between the current price and trading ranges over predetermined periods. Three values build a visual map of price over time, similarly to Bollinger Bands, indicating the extent of bullishness and bearishness for the chosen period. The top line identifies the extent of bullish energy, highlighting the highest price achieved for the period through the bull-bear conflict.

The center line identifies the median or mean reversion price for the period, highlighting the middle ground achieved for the period through the bull-bear conflict. The bottom line identifies the extent of bearish energy, highlighting the lowest price achieved for the period through the bull-bear conflict.

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Limitations of Using Donchian Channels

Markets move according to many cycles of activity.

 An arbitrary or commonly used N period value for Donchian Channels may not reflect current market conditions, generating false signals that can undermine trading and investment performance.

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