Trading with Donchian Channels

Richard Donchian (Source: Wikipedia)
Richard Donchian (Source: Wikipedia)

The Donchian channels, also referred to as Donchian Bands, is one of the famous channel indicators besides the more popular Bollinger Bands. It is a trend following channel indicator and has given rise to many different trading strategies including the famed ‘Turtle Trading Strategy‘ as well.

The Donchian Band is primarily used to gauge the volatility of the markets (similar to Bollinger Bands) and can also be used as a break out indicator as well as a horizontal support and resistance indicator. This means that when prices are stable, the Donchian channels tend to contract or narrow and when volatility picks up, the Donchian channels widen.

The Donchian Channel was developed by Richard Donchian a futures and commodities trader. Richard Donchian is also known within the trading fraternity as the one who pioneered the principle of ‘trend following‘ as well as being one of the first to introduce a ‘Rule based’ trading approach.

How are the Donchian Channels formed?

The Donchian Channels are simply two lines formed at the high and low, forming a channel. The upper channel is formed by taking the highest high of the past price bars while the lower channel is formed by taking the lowest low of the past price bars.

The chart below shows a 10 periods Donchian Channel applied to the daily charts. The default settings for Donchian bands is usually 20 period (ideal on a daily chart) but traders are free to change and use a setting that fits their need the best.

Donchian channels example illustrates volatility and high/lows
Donchian channels example illustrates volatility and high/lows

From the above chart example, we can see how the Donchian channel widens and narrows as and when volatility in the markets rises and falls. The upper and lower bands also plot the 10 period highest high and lowest low.

Some charting platforms also include the middle Donchian band. The middle Donchian band is an average of the upper and lower bands and this can be used as a trading signal as well as it is used to determine the trend strength.

Donchian Channel Trade Signals

At the simplest form, traders take long positions when price breaks the upper band (or posts a new high above the past ‘x’ number of price bars) and likewise, short positions are taken when price breaches the lower band (or lowest low of the past ‘x’ number of price bars). It works similar to a break out trading strategy.

However, having said that the Donchian bands also form levels of dynamic support and resistance and therefore it is not surprising to see prices bouncing off the upper and lower bands. The Donchian channel thus can be used also as an indicator that clearly specifies support and resistance levels on the chart objectively.

The chart below gives a few examples of how traders can trade on break out of the upper and lower bands while also using the Donchian bands to determine support and resistance levels. Notice how prices move strongly when previous support turns to resistance and vice versa. The Donchian channel therefore offers a very objective approach to support and resistance levels.

Donchian Channel Support/Resistance & Breakout
Donchian Channels Support/Resistance & Breakout

Using the Donchian Channels Indicator

The Donchian Channel indicator can be applied in many different ways, both as a trend following system as well as a short term scalping system based off the horizontal support and resistance levels that are formed.

Traders are sure to find tons of different approaches to trading the Donchian channel so we won’t bother with illustrating the same. A rather different approach using the Donchian channel indicator is to build support/resistance levels based off narrowing bands and trading them accordingly.

The chart below shows how we first plot two main zones of support/resistance. While we first plot the resistance zone near 1.25 region, prices contract near 1.225 region as the Donchian Channel contracts and then widens at this price zone. We can see how prices break the resistance level to form support and the subsequent rally allows price to reach our projected target zone of 1.25.

Donchian Band Trading Example
Donchian Band Trading Example

Besides the above simplistic approach, using oscillators can also help in picking turning points within range trading as well as for trading the Donchian channel break outs.