i. It is a trend following indicator developed by Richard Donchian.
ii. It is made up of 3 lines, an upper, middle, and lower line that creates a band around the price.
iii. Traders use this indicator as it shows breakouts and even tells about the volatility.
What is the Donchian channel indicator?
Donchian channel is a technical indicator developed by a futures trader named Richard Donchian. He was named The father of Trend Following.
Traders can then use this to trade breakouts, reversals, and even follow the trend. Some traders even use it for mean reversion.
On the look of it, the indicator comprises of three lines, an upper line, a lower line, and a middle line, all three lines enclose the candlesticks within them.
This indicator seeks to provide extremes on both sides i.e. bullish and bearish.
How does the Donchian channel work?
The indicator is made up of three lines, an upper and lower and a middle line. The middle line is optional.
These lines are formed by moving average calculations. The upper line is the high the price made over the time period and the lower line is the low the price made over the period.
The middle line is plotted after the high and the low of that particular time is subtracted and divided by 2.
The Donchian channel looks like an envelope that blankets the price and most of the price action takes place inside the channel.
The time period can be altered by traders. You can set the time period all the way from 1 to any maximum number but the default time period is 20.
This indicator can be applied to all timeframes and it will plot the lines according to the last 20 candlesticks in that timeframe.
It is suggested that traders work with the default settings, but if a change is required then you should do so only after testing different values and determining the best.
Why should you use the Donchian channel indicator?
Indicators are just tools that traders use to make trading easier for them. Just like any other indicator, the Donchian channel indicator is one that can assist traders in making trade decisions.
Now that I have discussed the construction of the indicator, let’s understand what traders can derive from it.
The Donchian channel basically looks to plot a high and a low and it is based on the high and low of the price over the past trading days.
When you look at the indicator on a price chart, you will notice that the price is always enclosed in it.
Each time the price approaches the high or low line, there is some kind of price reaction. And this reaction happens as the price is nearing a level that has not been broken for a long time.
Such levels act as major psychological levels and can even have the forces of demand and supply in play.
Since these price levels haven’t been broken in a while, there will be traders paying attention to such levels.
As and when price approaches these levels, there could be two possibilities, the price could break the level and trend, or it could bounce away from it and reverse.
The Donchian channel indicator is also useful to determine volatility. The wider the channel is, the higher the volatility and the narrower the channel is, the lower the volatility is.
In conditions of higher volatility, candlesticks will be wide and the price will have big moves, hence the channel will be wider.
It is widely known that a breakout is imminent after a brief period of low volatility. In such cases, breakouts taking place will have higher chances of being successful.
Donchian channel indicator strategies
The Donchian channel indicator provides certain opportunities for traders to take trades. Traders look to take complete advantage of all that the indicator offers and they devise strategies around them.
These strategies may differ from trader to trader and no one should blindly copy strategies. Whatever strategy I will discuss, should first be backtested and practiced and then only should you apply them in live markets.
You can tweak the strategies a bit according to your preferences and can even combine them with other strategies or indicators.
1. Breakout strategy
This is the most widely traded strategy using the Donchian channel indicator.
This indicator forms a band around the price and it either expands or contracts as per price movement.
We know that breakouts take place after consolidation. This indicator allows traders to clearly identify consolidation and breakout.
Apply this indicator on a price chart and look for periods where the channel becomes narrow. In this scenario, you will notice that the price is moving in a range. Mark the range.
Long trades are to be taken when the price breaks the range to the upside and if it breaks it to the downside then short trades should be taken.
Stop loss can be placed at the opposite end of the range or can be placed at the middle line.
Since this is a breakout trade, targets should be flexible, and instead of having fixed targets, traders should have multiple targets.
2. Middle line crossover strategy
Once there is a breakout from a range, the price will not always keep moving in the direction of the breakout. There will be a point where the price will stop trending in that direction and the trend can change.
This is where you can use the Donchian indicator to capitalize on such a change in trend.
In order to trade this, you should first look for a successful price breakout from a range, as we discussed in the breakout strategy. Once you spot such price movement, you should confirm that the channel has expanded.
Once these conditions are met, you should wait for the price to change trend and should then break above or below the middle line accordingly to take entries.
For instance, if the price saw a breakout from a range and it moved up, you should wait for the price to approach the middle line and break it to the downside. You should take a short trade here.
If the price declined after the breakout then wait for the price to break the middle to the upside and then long trades should be taken.
Stop loss can be placed at the lower band in case of a long trade and at the upper band in case of a short trade.
You can target the upper band when a long trade is taken and can target the lower band when short trade is taken. The targets are not a hard and fast rule and you can have different plans to exit.
3. Fakeout strategy
I like to call fake breakouts fakeouts and in this strategy, you can capitalize on breakouts that failed to materialize.
Like I discussed in the breakout strategy the price must break above the upper line or below the lower line.
Many times you will notice that even though the price breaks the band, it doesn’t actually explode in that direction. But rather it fizzles down and it looks like a reversal. You can look to take trades here.
If the price breaks the upper band to the upside but then it falls back then you should take a short trade with stop loss at the previous high.
In case of a failed breakout from the lower line, take a long trade with stop loss at the previous low.
You can set your target at the opposite band on the indicator or can even have different exit plans.
These were some strategies on the Donchian channel indicator standalone. You can also use this indicator along with other indicators to get additional confirmations.
1. Donchian channel and moving average
Apply both the Donchian channel and a moving average of your choice on the price chart.
Now, look for long breakout trades only if the price is trading above the moving average.
Short breakout trades should be taken only if the price is trading below the moving average.
This will allow you to trade in the direction of the larger trend and can avoid taking trades against the trend.
2. Donchian channel and oscillators
We know that oscillators are indicators whose value oscillates between two extremes.
These indicators indicate whether the price is in an overbought or oversold region.
RSI, Stochastic, MACD, etc. are examples of oscillator indicators.
You can use these indicators along with the Donchian channel indicator and can combine the signals of both and take trades accordingly.
The key is to get trade signals that are similar i.e. both indicators indicating buy trade or both indicating sell trade at the same time.
3. Donchian channel and volume indicators
Since we are looking to trade breakouts primarily using the Donchian channel we want to trade only successful breakouts.
Many times it is noticed that fake breakouts or fakeouts do not have adequate volume behind them.
You can use this as a heads up and combine the Donchian channel indicator along with volume indicators like On Balance Volume, Chaikin Money Flow, etc.
These were just examples of using the Donchian channel indicator along with other uncorrelated indicators.
This way you can take advantage of the information provided by two different indicators and take better quality trades.
But it should be noted that never trade any strategy, indicator, or combination of indicators in live markets unless you have practiced it.
When will you start using this indicator?
Do let me know if you decide to use this indicator in your trading and whether this blog post helped you out.
Share this blog post with other fellow traders and let them also explore this quality tool.
Feel free to ask questions in the comments section and I will get back to it at the earliest.