Donchian Channel

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

A Donchian Channel is a technical trend indicator based on the current price momentum and moving average calculations. It draws three lines, an upper band for the previous peak price, the lower band for the previous lowest price, and a middle line for the current average price. Its application help traders identify potential breakouts and trends in the market.

The Donchian bands are represented through the candlestick charts as a candlestick clearly outlines a trading session's open, high, low, and close price points. This technical analysis tool is considered an efficient indicator of the breakouts and retracements for the stocks, options, futures, and trade forex while depicting an asset's bullish and bearish extremes, making it a valuable resource for traders.

What is Donchian Channel?

A Donchian Channel is a trend following and reversion indicator that summarizes the performance of a security over the period into three bands, I.e., the upper channel or highest high price, the lower or the lowest low price, and the middle channel or average price.
It is a widely used trading strategy traders use to identify bullish or bearish security trends and breakout extremes.
The Donchian Channel trading strategy was proposed in the 1960s by an American futures and commodities trader, Richard Donchian.

Donchian Channel Strategy Explained

The Donchian Channel strategy was developed in the 1960s by Richard Donchian, a renowned American commodities and futures trader. Widely regarded as the Father of Trend Following Trading, his strategy is still popular among stock market traders for deciding whether to take a long or short position and for predicting emerging trends.

The Donchian Channel is considered one of the best trading indicators for intraday trading, providing a visual representation of a security's price variations over a given period that novice traders can easily understand. However, during an economic downturn, this strategy may not be as effective in predicting future price fluctuations. Other trend indicators, such as Bollinger Bands and Keltner, are available in the stock market. Selecting the appropriate indicator depends on the trader's risk-taking capacity, trading strategy, type of asset, and volatility.

How To Use It?

To calculate the three bands or channels in the Donchian strategy, we need to consider the following:

Upper Channel: The upper channel is the highest price point of security out of all the highs over the N periods.
Lower Channel: The lower channel is the lowest price point of security when all the low price levels of the N periods are compared.
Middle Channel: The median channel is the average of the highest and the lowest price points over the N periods, i.e., (Upper Channel + Lower Channel) / 2. The N period can be measured in minutes, hours, days, weeks, or months.

The Donchian Channel can be used for determining the volatility of stocks, futures, trade forex, and options. Thus, it is commonly applied in the following cases:

1. As a Breakout Indicator: The traders can take a long or short position using this indicator. If the stock trades above the upper channel, the trader can book profit by taking a long position. But, if the stock is trading below the lower band, the trader can benefit by taking a short position.

2. For Trading View with the Middle Channel: The average of the upper and the lower bands also serves as a crucial indicator of whether the trader should take a long or short position. If the stock price exceeds the median channel, the trader should take a long position. However, if it goes below that, the trader should be open to the short position.

In the chart given below, taken from TradingView, the pattern is clearly visible. In the chart, the two blue lines indicate the upper and the lower channels within which the candlesticks are lying. The middle yellow line is the one against which the movement of the candlesticks is compared. Suppose the candles continue to remain above the yellow line for quite a long period and form higher highs in the process, as is seenin the chart below. In that case, the market is considered strongly inclined towards a bullish trend.

If on the other hand, majority of the candles fall below the yellow line, it is important to understand that the market may begin to show a downtrend in the coming trading sessions. The trader should, thus, conveniently use this indicator to gauge the market trend, along with other widely used technical indicators to find support and resistance levels.

Source

Examples

Check out these examples to get a better idea:

Example #1

Suppose a stock has the following high and low prices in the past 20 days:

Let us determine the Donchian Channels for the same.

As we can see in the above table, the highest of the high prices is $11.4, and the lowest of the low prices is $7.8; these are the upper and the lower channels or bands, respectively. Thus,

UC = $11.4

LC = $7.8

And the Middle Channel = (UC + LC) / 2 = ($11.4 + $7.8) / 2 = $9.6

Hence, if a market shows a trend towards the upper band, I.e., $11.4, then the trader can profit from a long position; however, if the market moves towards the lower band, I.e., $7.8, then the trader can profit from a short position.

Example #2

Suppose a trader is following the stock of BCD Company and is interested in using a breakout trading strategy using Donchian Channels. The trader first looks at the stock's price movements over the past 20 trading days and records each day's high and low prices.

Next, the trader calculates the upper and lower Donchian Channels by taking the highest high and lowest low prices over the past 20 trading days. The upper channel represents the highest price that the stock has reached over the past 20 days, while the lower channel represents the lowest price.

The trader might use a breakout strategy when the stock price moves beyond the Donchian Channels. For example, if the price breaks out above the upper channel, the trader could consider opening a long position in anticipation of the price rising. Conversely, if the price breaks below the lower channel, the trader might consider opening a short position in anticipation of the price falling. By using the Donchian Channels in this way, the trader can potentially take advantage of significant price movements in the stock and profit from their trades.

Donchian Channels vs Bollinger Bands vs Keltner

The Donchian Channels, Bollinger Bands, and Keltner are all three technical indicators for framing the trading strategies. However, they differ from one another in the following ways:

Basis	Donchian Channels	Bollinger Bands	Keltner
Meaning	It is a trend indicator that applies the moving average method to determine the upper, lower, or middle bands.	It is the standard deviation area above and below the moving average stock price.	It indicates the price movement direction by representing the volatility-based bands on either the upper or lower side of the stock's price.
Methodology Used	Moving average calculation	Standard deviation	Exponential moving average and average true range
Reversal Trading Opportunities	Can be identified through this strategy	Can be identified through this strategy	Cannot be identified through Keltner
Accuracy	High	Comparatively low	High
Applicable for	Studying the market volatility, breakdown, breakouts, and potential trend of stock movements	Analyzing the strength of an asset's price rise and the potential fall	Spotting the trade opportunities and current trends when the stock price fluctuates between the upper and the lower bands

Frequently Asked Questions (FAQs)

1. What are the limitations of the Donchian Channel?

The limitations of the Donchian Channel include its reliance on historical price data, inability to provide signals during choppy or sideways market conditions, and tendency to produce false breakouts.

2. What is Donchian Channel scalping?

Donchian Channel scalping is a trading strategy that uses the Donchian Channel to identify potential breakouts and enter and exit trades quickly to capture small price movements. Traders using this strategy often use tight stop-loss orders to limit their risk.

3. What is the double Donchian Channel strategy?

The double Donchian Channel strategy is a trading strategy that uses two Donchian Channels - one with a shorter period and one with a longer period - to identify potential breakouts and trends in the market. Traders using this strategy often enter a long position when the shorter-term Donchian Channel crosses above the longer-term Donchian Channel and exit the position when the shorter-term channel crosses back below the longer-term channel.