Richard Donchian, a futures trader, created the Donchian Channel as a trend indicator. He was dubbed "The Father of Trend Following" later on. Several trading methods based on Donchian Channels have been established, but day traders can create their own because the indicator is versatile and can be interpreted in a variety of ways. The renowned Turtle Traders used a variation of the Donchian technique too.
What is the Donchian Channel Strategy?
Donchian Channel draws a line between an asset's peak and low price over a given period of time, generally using candlesticks as a clock. Candlesticks are plot regions on charts that show the open, high, low, close, and time frame of a certain stock. They get their name from their shape. The lines will form a channel around the current price when the indicator is applied to a chart.
When day trading, Donchian Channels are effective for highlighting trends as well as range periods. A third line might be added between the upper and bottom lines if desired. The upper and lower channel lines are averaged to form this mid-band. The indicator may be used on all time frames, including one-minute and five-minute charts (in which a bar forms every one or five minutes), and it can be used to trade forex, stocks, futures and options.
How Does the Donchian Strategy Work?
Since three bands show the current market movement, Donchian channels work.
- The upper band represents the previous period's highest high;
- The lower band represents the previous period's lowest Low;
- The centre band reflects the current high and low for that trading period as an average.
Traders will utilize Donchian channels to map the momentum in an underlying market, and they will use the channel's signals to open long or short positions at any time.
If an asset is trading in the Middle of the range with no significant deviations toward the upper or lower bands, the market is experiencing minimal volatility, and there may not be a clear overall bullish or bearish trend.
Traders could utilize this information to open a long position and profit from the market, gaining in value if the market is going towards the upper band. If the market is now heading lower, a trader will open a short position to profit from the market's decline in value.
Calculation of the Donchian Channel Indicator
The indicator's calculation is simple and uncomplicated, even for total beginners.
The technique is usually determined by the number of periods you want to use. A 20-day term is commonly used by traders. If we use that as an example, the indication will appear like this:
- 20-day Low in the Lower Channel
- 20-day High in the Upper Channel
- 20-day High + 20-day Low) / 2 Middle Channel
The method of calculating is straightforward. You must select the highest price for the provided period for the upper channel. Meanwhile, for the lower one, you choose the lowest price. The middle channel is the average of the two. Calculate the results and plot them on the graph.
Different Ways to Use Donchian Channels in Trading
It has the following applications:
1) Breakout Indicator | Donchian channels are used to identify a stock's breakout, which allows traders to take long or short bets. Traders can take a long position and record profits if the stock is trading above the Donchian channels or short the stock if it is trading below the channels. |
2) Trading with the Middle | The average of the lower and upper bands is used to calculate the centre band. This band is frequently utilized as a breakout sign in Donchian channels. When the stock climbs above the middle band of the Donchian channel, open a long position; when the price drops below the middle band, open a short position. |
How to Use the Donchian Trading System?
Step 1: To practice your Donchian channel strategy, create a demo account. Using our customized platform, choose which market and asset you want to trade and apply the indicator.
Step 2: Price action can be used to spot trading opportunities. When the asset's price diverges from the simple moving average line, look for it. To determine a bullish or bearish trend, look for a breakout above or below the upper and lower bars.
Step 3: Depending on the price direction, enter the trade with a long or short position.
Step 4: Some traders may choose to utilize a stop-loss order in the event of false breakouts or trend reversals. This can assist you in avoiding losing money in a tumultuous market.
Step 5: Only register for a live account to deposit funds when you're ready to trade with real money.
