Donchian Channels

Introduction

If there’s anything the stock market is well-known for it’s the volatility that’s so entwined with it. Yet if properly harnessed then it can create all kinds of wonders for the traders who know what they’re doing.

But how does one even go about doing that? Why through the help of indicators that can gauge that of course! And one such indicator that’s known for that is the Donchian Channels which we’ll be looking at here.

What are Donchian Channels?

Richard Donchian is the man who’s behind this indicator’s creation and he was quite a well-known American commodities and futures trader.

In fact he was even a pioneer in managed futures and established the very first futures fund called Futures Inc. in 1949! Not only that but he helped develop the model for those mutual funds within the United States.

As for what it’s even made for let’s look at that below.

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The Purpose of Donchian Channels

Donchian channels are simply a tool that technical analysts tend to use when determining the relative volatility found in various markets and the possibility of price breaking out.

To form it you have three lines being generated from those moving average calculations that generate this filled in channel that the lower and upper bands form around the midrange band.

But what do those bands mark really? Well the upper band notes the highest price of any given security across a certain period while the lower bands note the lowest price over that same period and the area between these bands is what constitutes that Donchian Channel.

Though relatively easy to get it’s still quite helpful in identifying trends and suggesting the correct time to exit or enter positions.

How are Donchian Channels Calculated?

Although you wont need to calculate the Donchian Channels on your own as mostly any platform that supports it will do those calculations for you automatically but if you’re still more of a curious type then look no further as we’ll be discussing that here.

Donchian Channel Calculation Steps

Basically speaking the Donchian channel is made by finding out the lowest and highest prices of stocks across a certain period of time which can be adjusted according to whatever style or strategy you want to use though the common or rather the standard is 20 periods which just so happen to be the typical number of trading days within a month.

That upper line is drawn at a period’s highest price  with the lower channel line drawn at that same period’s lowest and then there’s the line in the middle which reflects the average of the two extremes and how do you calculate that? Well you just add the upper and lower channel together and then divide them by two.

Key Characteristics of Donchian Channels

So as you may have gathered until now Donchian Channels  show the relationship between trading ranges and current price over certain periods.

Those three values then create this visual map of price across time like the Bollinger Bands depicting the extent of bearishness and bullishness for any given period.

Naturally the top line represents the extent of that bullish energy with the highest prices reached for the period.

The middle line in turn determines that period’s mean or median reversion price or the middle ground essentially.

As for the bottom line that would highlight the bearish energy or the lowest price ever hit for the period.

So this is pretty much it as far as the key characteristics go.

How to Use Donchian Channels in Trading

By now you must have gleaned some idea of what the Donchian Channels are all about and if so then you might be wondering how you could actually trade with it.

In this section that’s precisely what we’ll be looking into.

Trend Identification

One of the more obvious ways traders actually go about using this indicator is following trends and then strategizing accordingly.

For instance you may consider executing a long position on your stock when you see its price staying near or touching that upper band which could signal upward momentum.

But what about a short position? Well that can be done when you see something similar but on or near the lower channel that is.

The middle line can be quite useful too enabling one to acquire another means with which to see relative resistance or support within the assets’ prices.

Breakout Strategy

One other thing that traders may do with the Donchian Channel indicator is using a breakout strategy. Here if you see a breakout over the upper band then it could signal the start of a upward swing which implies possible buying opportunities.

At the same time if the price goes below that lower band then the time to sell or short the asset is nigh.

So basically determining when breakouts happen has to do with watching when that price goes beyond the lower or upper bands.

You should usually be able to confirm breakouts once those prices close at point below or above the lower or upper channels.

Reversal Strategy

But what about those reversals and how to identify them? It seems like most indicators nowadays have some way to determine when a reversal may happen and the Donchian Channels aren’t any different so if you see a flattening of some sort whether it be on the upper or lower bands during a trend then  it could mean that reversal may be on the way.

The reversal is more or less confirmed once you see that price moving above or below the middle line.

Using Donchian Channels with Other Indicator

If you want to improve the accuracy of this indicator or to just bolster your trading strategy then you can always use it in conjunction with another indicator such as the RSI or the MACD or you could even use those moving averages which there are various of.

Donchian Channel Strategies for Different Trading Styles

Now that yu have a fair idea of how you can go about trading with this indicator you might want to know how it can relate to some of the most popular trading styles or what people who use those styles could do with this indicator.

If so then read on as we’ll discuss that here.

Day Trading with Donchian Channels

If day trading is something that’s on your radar then what you could do with this indicator is employ a shorter time frame or period count since your priorities tend to lie within the short term.

As for what strategies would best suit that sort of style that could be scalping and trend following.

Swing Trading with Donchian Channels

But if you’re a swing trader then that means that it’s the medium to long term that has your attention and if that’s the case then you could always use the default setting or time frames  or just increase that to  better fit your needs.

Strategies that take use of reversals or assessing volatility may fit your needs better.

Long-Term Investing with Donchian Channels

As far as the long term is concerned any trader who’s into such kind of trading could always increase the period setting to whatever their preference is  and go about trading from there.

Breakout strategies or identifying trends and reversals could be better done here with the increased amount of time that there is to work with.

Advantages and Limitations of Donchian Channels

Using any indicator  will entail  you having to deal with its limitations and knowing them beforehand will go a long way in doing just that.

Benefits of Using Donchian Channels

Starting off with those benefits. First things first it’s easy or simple to use, it’s customizable and can identify trends, breakouts and provide clear exit or entry signals.

Limitations of Donchian Channels

As for those limitations well there’s always the possibility for false breakouts or signals. Then there’s how it’s a lagging indicator too and the fact that within sideways markets it wont work that well.

Conclusion

Donchian channels can be an incredible tool in your technical analyses offering you the means to discover trends and signs of breakouts.

When you integrate them with other analytical tools such as the MACD or RSI they could deliver a more thorough or comprehensive picture of market momentum or trends.

But as with anything you as a trader should be aware of its limits particularly within sideways markets and be able to verify any price signals prior to trading based on them.