Donchian Channels
There are several different types of trading bands, envelopes and
price channels from the best-known Bollinger Bands to starc and
Keltner Bands. Each of these is similar in appearance but how
traders use and apply them varies considerable.
Channels are a trading favourite because they define general
boundaries within which most of the price action should occur. The
flow of prices within a channel has been compared to a river in a
valley. When the river reaches one side of a valley, it turns back
toward the centre or perhaps even the opposite side of the valley,
depending on the path of least resistance. Like a river, prices also
will occasionally jump their channel banks when there is a torrent of
buying or selling.
A less familiar type of channel is known as a Donchian Channel,
named after Richard Donchian, a pioneer in developing technical
analysis techniques and managed futures funds going back to the
1940s. The basis of the Donchian Channel is rather simple: the high
close and the low close for the last N periods form the upper and
lower boundaries of the channel.
Analysis of the Donchian Channel is similar to other channels. In
general, the channel helps you see where you might expect to find
support and resistance - in this case, based on actual high and low
closing prices for a specified period rather than a percent variation
from a moving average as is the case with some other channels.
Donchian developed his trading technique based on a breakout of
the price range – a classical approach later included in several
trading systems, notable the Turtle trading system and a number of
mechanical price-range breakout approaches. This is enhanced
visually by drawing price channels and identifying closes outside the
channel lines. Whilst this approach may be traded systematically as
a breakout, the trader’s chances of success are increased if there is
already a trend in place or beginning to establish itself.
Let’s look at a chart of crude oil and draw a Donchian channel to
examine the trading possibilities. Here we have drawn an upper
boundary based on the high prices over the previous 20-day period
and a lower boundary based on the low prices over the same
period. This is a variation of the Donchian Channel in that he took
closing prices rather than high or low price extremes. It is always
important to trial and error and back-test with any technique until
you are comfortable that it suits your trading style. The application
of highs and lows rather than closing highs or closing lows merely
reflects a different style rather than a different technique. We have
also used a 20-day period whereas Donchian favored a 4-week or
30-day period.
The first breakout occurs in May when the price closes outside the
upper channel. This is a signal to enter a long position. There are
two possible entry triggers: either place a buy order at just above
the high of the period or wait until the price has been established as
the closing price for the day and place a buy order for the open on
the next day. This buy order should be placed just above the high
for the previous day and sometimes may not be triggered
straightaway.
The direction of the channel is important in deciding whether to
enter the trade. If the channel is moving up, trade from the long
side, buying on a breakout above the upper channel or on dips to
the lower side of the boundary. In the three long entry signals
shown as blue arrows the entry was taken only if the upper channel
line was pointing in the same direction as the signal. Two of the
three long breakouts led to profitable positions. The third marked as
FB was a false breakout and was a high for the period.
If the channel is pointing down, it is appropriate to trade from the
short side, selling on a breakout from the channel or on rallies to
the upper side of the boundary. In this example there was a
profitable short position, shown by the red down arrows in early
September.
Another approach would be to use the mid-point line as your trigger
point (the mid-point may be the mid-way point between the two
boundaries or, as here, we have selected a 20-day moving
average). When prices fall below the mid-point, sell; when prices
cross above the mid-point, buy.
Of course, that approach has the same problem as many others in
choppy, sideways conditions. It may result in whipsaws and false
entries. We would then suggest that an appropriate filter is also
applied to decide on the suitability of taking a position. Here we
show the same chart but with a Detrended Price Oscillator (DPI)
drawn at the bottom of the chart (see The A to Z of Technical
Indicators for a full explanation of how this indicator is applied).
The oscillator shows a divergence from the price action where the
peaks in the DPI do not coincide with price peaks during July and
August. This is likely to have kept us out of the false breakout trade
in early August. It also signaled confirmation of the long position to
be taken in October.
Finally we show the same chart with Donchian’s 4-week (30-day)
channels (drawn as green lines). For the long entry triggers two of
the entries were later than with the 20-day entry although the short
position had the same entry point. Generally the 30-day trigger will
lead to fewer trades and whipsaws whilst capturing the majority of
the longer, trending moves.
With channels, you often get a second chance to buy or sell as the
market tests its boundaries and then reverts back to a more normal
mid-point position, but keep in mind that a channel is only a
guideline. For better signals, you should combine the use of a
channel with a technical indicator that highlights divergence with
prices.
The intention behind this introduction was to emphasize the validity
of Donchian breakout approaches to trend trading, particularly
where entry is concerned. However the Donchian approach does not
provide a ready exit strategy although it offers several alternatives.
The successful trader always knows what the initial risk is with
every trade and also has a clear exit strategy to get out of a
winning trade (or a losing one). Exit strategies were discussed in
our previous Newsletter available on the Articles and Downloads
page and feature strongly in both our E-Books.
With the application of Donchian channels three exit strategies are
suggested for review by the trader:
1. An exit when prices move to the lower end of the price channel in
the event of a long position i.e. draw a mid-point line and exit when
this is crossed. This is in effect a 50% retracement line and would
normally be suggestive of a price reversal or a profit-removing
correction.
2. Apply an N-day simple moving average of closing prices and exit
when this is crossed. The period may be the same as the channel N-
day period although we would tend to apply a 20-day moving
average for a 30-day channel. This trailing stop is also changed
daily and should move closer to the price action as the price range
contracts.
3. Use a trailing stop based on an N-day low for long positions or Nday high for an exit from a short position. For example if a 20-day
Donchian channel is selected for a long entry, then take the low
price (or low closing price) of the past 10-day period and use it for
the exit price. This may not change daily although the 10-day low
must be monitored and updated if a new low is made.
Whichever exit strategy is adopted, Donchian channels provide an
excellent entry for riding a trend.