What is the Donchian channel?
Simply put, the Donchian channel is a technical indicator used by traders to identify volatility, breakouts, and emerging bullish or bearish trends regarding the price of a security or currency.
In addition, the following particulars about the Donchian channel are noteworthy:
- The indicator was created in the 1960s by Richard Donchian, the legendary futures and commodities trader, who had the nickname, ‘The father of trend following trading.’
- It is considered to be one of the earliest forms of trend following.
- Traders can apply Donchian channels in different types of financial markets, such as futures, stocks, and forex.
- Donchian channels are usually used with candlestick charts in order to clearly map information obtained from the Donchian channel.
What is a candlestick chart?
A candlestick chart comprises individual candlesticks, consisting of a candle body, upper and lower candlewick. The body indicates the opening and closing price of a security of a specific period. The tip of the upper candlewick reflects the highest price of the period and the lower candlewick shows the lowest price of the period.
In short, candlesticks enable traders to understand price action during a specific period.
A green candlestick, referred to as a bullish candlestick, signals that the closing price of a security of a specific period was higher than the period’s opening price. Contrarily, a red candlestick, called a bearish candlestick, indicates that the closing price of the period was lower than its opening price.
The formation of Donchian channels
A Donchian channel comprises three bands, indicating the current market momentum. The upper band, also referred to as the resistance band, represents the highest high of a security’s price of the previous period, while the lower band, also called the support band, represents the lowest low of the previous period.
The difference between the upper and lower band constitutes the channel over a particular period.
The middle band represents the average of the current high and the current low for the specific trading period.
Calculating Donchian channels
Normally, most trading platforms will calculate the Donchian channel for a trader. However, you can use the following formula to calculate a Donchian channel yourself:
Upper band = The highest price in the previous n periods.
Lower band = The lowest price in the previous n periods.
Middle band (median band) = ((Upper band – Lower band)/2)
The default n can represent periods such as minutes, hours, days, or months, depending on what period of time a trader prefers to calculate the indicator for.
Generally, the default can be 20 periods or 50 periods, depending on the trading platform. Although, traders can set their own number of periods, depending on their own specific needs.
For example, let us say we are looking at an hourly price chart of the EUR/USD currency pair and we are using a setting of 20 periods for our Donchian channel. The highest high for the 20-hour period was 1.1920 and the lowest low was 1.1890.
Based on the information above, the Donchian channel’s upper band would be plotted at 1.1920 and the lower band at 1.1890. The median band would be drawn at 1.1905.
Interpreting the Donchian channel
Charting software positions Donchian channels over a price chart, enabling traders to identify comparative relationships between the current price of an asset and tradings over predefined periods of time.
Put differently, Donchian channels are placed over a price chart by means of charting software, allowing traders to envisage where the current price is relative to the upper and lower bands of the channel.
Generally, the shorter the periods and the stabler the prices are, the more compressed the channels will be. Contrarily, less stable prices and larger data sets will cause wider channels.
The width of a Donchian channel is an indication of the price volatility of a security or currency. A narrow channel signals low volatility, while a wide channel is an indication of high volatility.
In addition, when the Donchian channel is sloping upwards and prices are touching the upper band, it reflects an extremely bullish underlying market.
On the contrary, when the indicator is sloping downwards and prices are starting to reach the lower band, it is an indication of enormous bearish pressure.
The Donchian channel was developed to present a visual image of price behaviour. The three bands are used in the following ways:
- Upper band: To determine the underlying bullish trend of the price.
- Lower band: To gauge the underlying bearish pressure of the price.
- Middle band: To identify when a trend can restart after a retracement (i.e. a short-term period of movement against a trend), or when there is a potential price trend reversal.
Trading Donchian channels
As already mentioned, the Donchian channel is primarily an indicator that can be used in trading securities or currencies to:
- identify volatility in price,
- Identify breakouts (bullish or bearish), and
- follow a particular trend.
Generally, the middle band (line) is used by many traders as a guideline of when to open or close a trading position.
When the trend is bullish
Normally, when the price of an asset rises above the middle band, traders will open long positions and maintain them until the price touches the upper band. When this happens, traders will have a choice to make:
- If no breakout occurs, meaning the price does not break through the upper band, many traders will close their long positions and instead open short positions, expecting a reversal of the bullish trend.
- If the price breaks through the upper band (breakout), it could be an indication of a bullish market, continuing for a certain period of time. Typically, in this situation traders will keep their long positions open as long as the asset’s price is consistently closing above the upper band. This strategy is followed in order to avoid the possibility of trading a false breakout.
As a safeguard, stop orders can be utilised to protect a position against any bearish reversals.
When the trend is bearish
When the price of a currency or security moves below the middle band, traders will open short positions, holding them until the price reaches the lower band, presenting a trader two options:
- If the price hits the lower band but does not close below the band (no breakout), it could be interpreted as an indication of an imminent price reversal from bearish to bullish. In this scenario, a trader might close a short position and choose to open a long position.
- If the price of the security/currency falls below the lower band, traders usually will keep their short positions open in anticipation to gain from a possible bearish rally.
As protection against a possible false breakout, many traders will wait until the price has closed at least twice below the lower band. In addition, a trader could utilise a stop order on the short position, safeguarding him- or herself against possible bullish reversals.
Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.
Top 4 Brokers
