What is a Donchian Channel?

Source: asktraders.com

Introduction

The Donchian channel, developed in 1936 by futures trader Richard Donchian, shows both high and low asset values over a specified time, using candlestick markers to define precise time intervals. Candlesticks are employed as graphic indicators on market charts to display the highest, lowest, opening, and closing values of an asset.

The term “candlesticks” was derived from their cone shape. For day trading, Donchian channels are frequently employed to assist traders in highlighting trends and range periods (the gap between an asset’s peak and minimum price within a specific timeframe).

In addition, Donchian channels provide the option to trace a third line, known as a mid-band, between the low and high lines previously stated (the top and bottom lines are referred to as “channel lines”). By measuring the aggregate of the channel lines around it, this mid-band is identified. Donchian channels are especially helpful for day traders since they can be used on any type of financial market and perform well on all timescales. Donchian channels have historically been utilized by analysts to assist them to spot and profit from breakout positions that signify a movement from a prior high or low to generate an immediate lower or higher high.

Further, the Donchian channel is a chart analysis trading method used as a signal for trading on stock markets. Traders mostly use this signal to spot possible breakouts and retracements. A breakout is when the price of a security rises above a resistance level (prior high) or falls below a support level (previous low). A retracement, on the other hand, is when the value of an asset begins to return to its prior level after experiencing a substantial fluctuation, such as when a stock declines by 25% and then rises by 22%.

Brief History of Donchian Channel

The Donchian channels were created by prominent American commodities and futures trader Richard Donchian. He was a forerunner in managed futures, founding Futures Inc., the first futures fund, in 1949. He also helped develop the U.S. mutual fund model.

Donchian created a comprehensive set of trend-following trading rules while working as an exchange analyst, earning him the title of “the father of trading by following the trend” in the process. Numerous exchange trading systems were developed based on these guidelines, some of which are still in use today.

How Does Donchian Channel Work?

The Donchian Channel employs three bands, the upper band displays the maximum price from the prior period, and the lower band displays the lowest price from the same period. The average of both prices is then depicted by the center line.

The three bands allow traders to establish a position in the market to profit from an anticipated spike or decrease in value giving predictive signals. These bands show the live market activity of a stock or financial asset.

A bullish trend, which signals a long position of a financial asset or the market in general, may be present if the market is trending upward. Likewise, a bearish trend is indicated if the market trend is heading in the direction of the lower band — these signal traders to establish a short position. The middle line, however, may imply lower market volatility, and a hold strategy may be used while waiting for additional signals.

How to Calculate Donchian Channel Parameters?

Source: IG International — ig.com

The upper band, lower band, and average middle line are all separately calculated while calculating Donchian Channels.

The calculation looks like this:

• Upper band: Maximum price during the previous N periods.
• Lower band: Minimum price during the previous N periods.
• Middle line: Upper band minus lower band divided by 2.

Based on the measurement timespan being observed, which includes minutes, hours, days, weeks, or months, and may have varying duration lengths. This duration will be the number of sessions being monitored (30 minutes, 24 hours, 20 days, or 1 week). The standard trading time for Donchian Channels is 20 days, which corresponds to the typical duration for trading in a month.

Trading Methods for Donchian Channel

On Donchian Channels, there are primarily two methods: one that considers a potential bullish trend and the other that considers a potential bearish trend. Traders distinguish between these two strategies using the middle line. The typical trading technique that allows a trader to constantly monitor the market and hunt for exit strategies is the Donchian Channel.

The Donchian Channel’s technique is a price volatility indicator; the channel will be quite tight if price changes are minimal, showing low volatility. The channel will, however, be rather wide during times of extreme volatility when price fluctuations are significant.

Bullish Trading Method

Source: IG International — ig.com

A bullish trend is indicated if the price of an asset crosses above the middle line, which is a sign for traders to open a long position. To observe if the price hits the upper band, traders will retain a long position open.

Traders will probably end their long positions and initiate short positions if the price reaches the top band but fails to break through it, predicting the price to fall more toward the middle line. But if the price breaches the upper band, it indicates the continuation of a bullish trend, and traders can hold onto long positions.

Typically, traders desire that the price closes continuously above the upper band for a specific time frame in order to protect themselves from trading a false breakout. Stop signals, like guaranteed stop loss, are used in the trading protocol to avoid a bearish retracement on this strategy.

Bearish Trading Method

Source: IG International — ig.com

If an asset price falls below the middle point, traders are to open short positions. Unless the price reaches the lower band, traders retain this position. Normally, traders will terminate their short positions and start long ones on the asset, expecting a bullish trend along the middle line if the price hits the lower band without breaching it.

However, traders will hold onto a short position in anticipation of a prolonged bearish trend if the price breaches the lower band and continuously falls below the lower band for a specific duration. While traders are maintaining short positions, stop controls are also used for risk management to avoid a bearish trend.

Note: A trader has two options when trading assets: long positions and short positions, these are otherwise known as buy and sell respectively.

Strategies for Trading Donchian Channel

The following are two important trading methods that are commonly applied by traders: breakout trading and reversal trading methods.

Breakout Trading Techniques

With this short to medium-term trading technique, the trader initiates a particular trend as quickly as possible in the hope that the asset price would cross the higher or lower band, or breakout from its present trading range, through a prolonged bullish or bearish trend.

Reversal Trading Technique

With this approach, a trader can pause for a trend reversal from the present trend to happen before executing a short or long position, based on the trend reversal.

How to Apply Donchian Channel in the Crypto Market?

Source: Steemit

Due to the indicator’s numerous properties, Donchian Channel has a wide range of applications. Cryptocurrency traders must examine the market and every facet of the set of interactions between bulls and bears. The indicator’s use in the trading process would thus be of interest to traders. To precisely identify where to enter and exit long or short positions, the following are the main scenarios and tactical suggestions for the successful application of the Donchian Channel.

Market Volatility

Given its capability to accurately reflect price volatility, the Donchian Channel is recognized as a volatility indicator. Traders can quickly determine whether to take a trade position or not by figuring out the market’s level of volatility. Additionally, it aids in preparing traders to respond appropriately to drastic changes. For instance, if there is little volatility and the value is in an upward trend (bulls), there is a good possibility that the upward movement will last for some time.

This is a great chance for traders to take a long (buy) position. The price could become more uncertain when volatility rises, but this presents another excellent opportunity to open positions, although the strategy should change.

Breakout Trading

Applying the Donchian Channel indicator with breakout trading is one of the most common uses for it. The two most common kinds of breakouts, however, are trade breaks of the higher or lower channel levels or trade breaks of the middle channel level in both ways. In essence, it is used by cryptocurrency traders to look for signs to initiate long (buy) or short (sell) positions.

Every time the upper line of the channel crosses the previous high, indicating a potential long position, or every time the lower line crosses the previous low, indicating a potential short position, the signals can be seen. Simply put, trades are established when the price crosses the top or bottom of the channel’s extremes. This implies that the trend will likely stay that way for a bit. This is because the upper band serves as the resistance level while the lower band serves as the support level.

Middle Line

The midline can potentially deliver reasonable indications in addition to the channel’s extremes. For instance, a cryptocurrency is moving with minimal departures toward the higher or lower band, and it is mostly trading in the midline. In that instance, it is safe to assume that there is no current predictable pattern and that the value is undergoing low volatility, the channel would tighten in this situation. However, it is prudent to consider a long (buy) position and profit from the upward rise if the market moves toward the upper band. Traders might go short if the movement is in the direction of the lower band.

Example of a Donchian Channel Technique

Source: asktraders.com

Any trade asset, such as cryptocurrencies, can be executed with the Donchian Channel technique. This method includes some clear trading guidelines, which ought to interest beginners. The bullish possible case will be used to illustrate the method for simplicity. However, it still holds true in bear markets. The guidelines are as follows:

• Create a chart and add the Donchian Channel indicator. The indicator should be first placed on the chart, ideally a candlestick type.
• Watch out for the price slide toward the upper line. The second stage is to watch the price consistently move towards the upper line of the channel for some time. The price shouldn’t fall below the midline throughout this time (median line). So the price should follow the upper side of the Donchian Channel. That shows that the bullish trend is strong as the price of cryptocurrency is rising.
• The next best course of action is to watch for a reversal in which the price movement shifts to the middle. When the price crosses the lower band or breaks below the midline, a trader is safe to initiate a long position. If the price retreats to the middle line, it is advised that traders start a long position and then start a second trading decision when the price drops even lower towards the lower position. There is no requirement for a second purchase order if the price immediately recovers after breaching below the midline. This however is the best time to employ a powerful risk management strategy in this approach.
• Placing a stop-loss signal, which ought to be positioned below the lower range of the Donchian Channel indicator, is a crucial risk management measure. If the price moves against the trade, the stop order will stop any further losses.

Common Errors to Avoid When Trading with Donchian Channel

Source: tradingwithrayner.com

Trying to utilize the Donchian Channel to identify overbought and oversold ranges is one of the biggest errors day traders make. According to these traders, if the price is approaching the top band, the trade market is overbought and will inevitably begin to decline soon. When the price reaches the upper band, some traders may even start opening short positions. The rise, however, can last longer, leaving a reckless trader without enough money to hold the position.

To obtain more accurate information regarding the market’s probable overbought or oversold levels, one can instead make use of momentum indicators such as the Relative Strength Index or Stochastic oscillator. If not, the trader will probably accuse the Donchian Channel of supplying incorrect information.

Advantages of the Donchian Channel

• The Donchian Channel has established itself as a highly effective trading indicator with time in terms of its capacity to spot market volatility and generate a market value that combines the peaks and lows of a specific time frame.
• Donchian Channels compress to display a constrained range and minimal potential for profit for day traders when asset values are stable.
• Donchian Channel readings will widen when market prices vary, and this is typically the kind of scenario that is conducive to trade profits in either bullish or bearish directions.
• Traders can use Donchian Channels to decide whether to open long or short positions based on the market’s overall direction.

Disadvantages of the Donchian Channel

• It is important to realize that markets typically follow the fundamental financial cycles that affect the whole world economy, in this case, the Donchian Channel has little or no control.
• In reality, the precise time intervals that are chosen to plot a Donchian channel on a technical analysis trading platform could not be an accurate representation of the actual economic conditions that exist in the market.
• There is a higher chance that perhaps the Donchian Channel would produce erroneous trade signals that might potentially limit gains and impair trading outcomes in the short run.

Conclusion

The Donchian Channel indicator is typically used to spot possible trend distortions in the market. When individual price swings are dramatic enough to signal that an asset has become either overbought or oversold, Donchian Channels typically have the largest success rates. They can become extremely beneficial in this way when traders are seeking recent trend moves when they are still in an early stage.

Also, trading techniques using bullish Donchian Channels enable traders to buy as market rates decline to the lower line and start to reverse higher. Bearish Donchian Channel trades, on the other hand, concentrate on taking short positions when market prices reach the upper barrier before turning downward.

However, another technical analysis indicator should be included as a confirming tool for traders who want to employ the Donchian Channel in an active trading strategy because doing so frequently increases the likelihood that trades will succeed over time.