Donchian Channel: How to identify Breakouts and Reversal

Technical analysis is the most important method that Wall Street and other professional traders use to gauge the movement of financial assets.

It is the same model that has helped create the biggest algorithmic trading companies like Renaissance Technologies, the hedge fund ran by Jim Simmons!

In the past few weeks, we have continued our emphasis on technical analysis. We have looked at popular indicators like moving averages and those that are relatively unpopular like the Relative Volatility Index.

In this report we will look at Donchian Channel, an indicator that is not very well known.

What is the Donchian Channel?

The Donchian Channel is an indicator that is not provided as a default of most trading platforms like the MetaTrader.

It is an oscillator that was developed by Richard Donchian, who is widely known as the father of trend following.

When applied, the indicator looks like the Relative Strength Index. This is because it has three lines.

Traders use the indicator to measure volatility and identify potential breakouts and reversal areas.

How to Use this indicator

Using the Donchian Channel is relatively easy. There are two things you need to know.

First, you need to conduct a visual look of the chart you are trading. This can be a stocks, forex, commodities, or crypto charts. Looking at the chart will make you see whether the Donchian Channel is ideal to be used there.

Ideally, the channel should be used when the asset you are trading on is trending and not what it is consolidating. When used in a consolidating asset, the signal may not be accurate.

Second, you need to tweak the period that is provided. The default period is usually 20 but you can change it based on your trading strategy.

Built Up a Donchian Channel Trading Strategy

As mentioned above, the Donchian Channel has three lines. The two outer lines are probably the most important. The strength of a trend is usually seen by considering these two lines.

For example, as shown in the chart below, in a strong upward trend, the upper shadows of the price usually touch the upper line of the Donchian Channel.

The opposite is true. In a downward trend, the price usually test the lower line of the Donchian Channel.

Therefore, this beats the convectional logic that says that you should short when the upper channel is tested.

Another thing you need to observe is the flattening of the upper and higher lines during a trend. When this flattening happens, it is usually a sign that the reversal is coming.

The reversal is usually confirmed when the price of an asset moves above or below the middle line.

interpretation of DC

How to read DC

Double Channel Strategy

This is not the only way of using the Donchian Channel.

Another common way is to combine the Donchian Channels. This is a strategy that is similar to a double moving averages strategy.

The idea is to have two Donchian Channels with different periods. You can have one with the 20 default option and another one with a shorter option like 10.

When you apply it, the chart will look a bit cluttered because of the six lines. You can sort this out by tweaking the colours of these lines.

When doing this, a buy signal is usually generated when the price of an asset moves above the upper line of the longer-dated period.

Your exit should come when the exit price declines below the lower line of the band. The opposite is correct. A sell signal is made when the price falls slightly above the lower band of the longer-dated line.

An example of this is shown below.

double donchian channel

Double Donchian Channel

Donchian Channel & Bollinger Bands

Another popular way We use the Donchian Channel is to combine it with the Bollinger Bands. The two indicators are usually relatively similar in appearance.

The reason for combining the two is to confirm when a signal is formed. The chart below shows a 20-period Bollinger Bands (shown in red) and the Donchian Channel (shown in black).

As you can see, an uptrend happens when the price is along the upper lines of the Donchian and Bollinger Bands.

Donchian and Bollinger Bands

Donchian & Bollinger Bands

Summary

The Donchian Channel is not a popular trading indicator. However, We know many leading traders who swear by it.

In this article we have looked at who developed and how you can use the indicator in the forex, stocks, and crypto market.

We recommend that you take time to read more about the indicator. Also, you should try it using your market style and see how it works.

External useful Resources

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