What are Donchian Channels?

25 February 2021

    The Donchian Channels indicator is a technical analysis indicator devised by Richard Donchian, a futures trader, during the mid twentieth century. Donchian Channels is a volatility assessment indicator, and it provides traders information about the current market volatility, trend direction and well as important support and resistance levels. It is composed of three bands, an upper one and a lower one, which mark the highest and the lowest prices for the selected symbol for the past N periods, as well as the middle band, called the centerline, which denotes the average price between the two bands. The range in between the Donchian Channels indicator bands defines the range of values within which the price has been moving during the last N periods. The Donchian Channels indicator is an indicator that is used to identify breakouts that could be used as successful entry points as well as possible trend reversals which could be used not only as entry points, but also as a successful exit strategy.

     

    Donchian Channels Indicator Calculation

     

    The three bands of the Donchian Channel indicator are calculated as follows

     

    Upper Band= Highest High in Last N Periods

    Low Band= Lowest Low in Last N periods

    Middle Band=((Upper Band - Lower Band)/2)

     

    These three bands are then plotted on the chart and the area between the upper and lower band is considered as the Donchian Channel. This area is sometimes plotted with a semi-transparent color, so it can be easily identified on the chart.

     

    Donchian Channels in Fondex cTrader

     

    Donchian Channels indicator displays three lines on the symbol chart. We can see an example of a plotted Donchian Channels indicator from Fondex cTrader below.

     

     

    To add a Donchian Channel indicator in Fondex cTrader, right-click on the chart and navigate to Indicators > Volatility > Donchian Channel. After clicking on Donchian Channel, the below form will appear.

     

     

    In this form you select the Periods used to calculate the Donchian Channel bands, the Shift, customize your line’s color thickness and type and press OK. The Donchian Channel indicator will be added to your chart.

     

    Donchian Channels Strategies

     

    There are several ways to use the Donchian Channels indicator in your trading strategies. We present the most popular ones below.

     

    Band Breakouts

     

    The Band Breakouts strategy is a trading strategy that aims to identify price breakouts above support and resistance levels which could lead to the formation of new trends. The Donchian Channel indicator is mostly used by traders to map current market volatility and make decisions based on that. The Donchian Channel encloses the area in which the price action has taken place for the last N periods. Therefore, the upper and lower bands serve as support and resistance levels, in a similar way that Bollinger Bands do. Traders use these support and resistance levels to trade possible price breakouts. The price moving above the upper Donchian Channel band or below a lower Donchian Channel band is an indication of a possible trend start. Hence, it can be considered a good point to enter a long or a short position.

     

    Below we can see some examples of such breakouts

     

     

    In the chart above, you can see the price for EUR/USD ranging within the Donchian Channel for a period of time until it breached the upper band of the channel. After the break out, a strong upwards pressure was created moving the price to new highs. This is a good example of a buy signal using the Donchian Channel indicator, and a trader using this strategy should have entered a buy position at this point.

     

     

    Respectively, the chart above demonstrates a break out below the resistance zone formed by the lower band. In this case, this was the start of an extended bearish trend. This time the channel break out was a good signal for a short position.

     

    The  Band Breakouts strategy is a strategy that provides very good trend start signals. Nevertheless, it is very frequent to observe false breakouts using the simple band breakout strategy. Therefore, it is not uncommon for many traders to combine this strategy with another indicator that provides information about the direction of the trend and consider breakouts only towards the direction of the underlying trend. Such indicators are moving averages, RSI and MACD. Some traders also combine band break outs with price patterns.

     

    Center Line Breakouts

     

    Another popular method of using the Donchian Channel indicator is by utilizing the centerline as a breakout and trend reversal level. The centerline can be used by traders that want to trade in a more aggressive way and more often than traders who trade using the upper and lower bands, since centerline breakouts occur more often than band breakouts. Using the centerline breakout strategy, when prices cross over the centerline to the upside - we have a buy signal, and when prices cross the centerline to the downside - we have a sell signal. The chart below shows an example of such a signal in each direction. 

     

     

    In the EUR/USD chart above, we can see how a price crossing the centreline level initiates trend reversals in each respective direction. 

     

    Also, the centerline is very often used as an exit signal and a trailing stop loss when the position has been entered using a different signal e.g. a band breakout or a signal from a different indicator.

     

    As with all trading strategies, the centreline strategy can be improved by combining the signals with other confirmatory information as other indicators of price action in the chart.

     

    Limitations of the Donchian Channels Indicator

    The Donchian Channels Indicator, as any other technical indicator, always needs to be used in context. An out of context interpretation of Donchian Channels Indicator patterns can generate a lot of false signals that could lead to substantial losses. Therefore, when using the Donchian Channels Indicator, always consider the market fundamentals that currently move the market, and combine the signals with other confirmation signals, like trend indicators, support/resistance levels and the relevant price action taking place on the chart.

     


    *The products advertised are only available to clients under Fondex Limited Seychelles (SDL No: SD037).

TAGS
#Educational#DonchianChannels