Donchian channels are used to identify an asset’s volatility, price breakouts, and breakdowns. The Donchian channel strategy helps traders identify overbought or oversold conditions of an asset.
In general, traders use Donchian channels to identify bullish momentum breakout stocks to go long and bearish breakdown stocks to go short. Donchian channel breakouts occur when the asset’s price is above the channel high. Similarly, Donchian channel breakdowns occur when prices move below the channel low.
Donchian channels are easy for beginners to grasp and flexible enough to be applied to charts of forex products, stocks, options, and futures. Donchian channels are most effective when used together with other technical indicators to filter out noise and confirm trading signals.
What Are Donchian Channels?
Donchian channels help traders by displaying a security’s price volatility, potential trend breakouts and breakdowns, and possible overbought and oversold conditions.
Three lines are used to construct a Donchian channel. The channel high (upper band) is the highest price of an asset over a given time period. The channel low (lower band) is the lowest price over a given period.
The center line is simply the average of the high and low channels.
Traders can select any lookback period, although 20 periods is typical. Candlestick charts are often used when Donchian channels are applied as they enable better identification of channel crosses than line charts.
Donchian channels also have the flexibility to be used on a variety of asset types including options. If you are a beginner looking to trade options, this is a strategy to consider.
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How Does a Donchian Channel Work?
Donchian channels work by helping you find stocks that are potential candidates for bullish breakouts and bearish breakdowns.
This indicator works similar to Bollinger Bands, but Bollinger Bands are less sensitive to big high or low prices and use a security’s standard deviation to form its bands. Additionally, breakouts identified by Bollinger bands identify trend reversals whereas breakouts of Donchian channels identify new trends in the same direction.
While the bands of a Donchian channel can be seen as potential support and resistance, traders often use this technical analysis indicator to spot momentum entry prices on a stock. For example, you might enter a long position when a share price breaks through the channel high. You can also use the Donchian channel to find short stock candidates — those with breakdowns through the channel low.
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Donchian Channel Strategy
The Donchian channel lines help a trader develop support and resistance areas on a chart. This indicator is often used with others to form a trading strategy.
While a 20-period setting is often used, Donchian channel trading can be used with any timeframe. Some strategies use four- or five-week periods. A common Donchian channel strategy is to wait for a stock to breakout above the channel high, then buy that stock.
You can also wait for a bearish breakdown through the channel low to short a stock.
With your trading strategy, it is important to know the risks and limitations of Donchian channels. It might be tough to discern if price poking through the channel high is a true bullish breakout or a sign of a reversal without confirmation from other technical indicators.
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Your trading strategy should also be aware of how arbitrary Donchian channels can be — a commonly used n-period value might not be an ideal gauge for market or stock-specific conditions.
False signals can trigger and hurt trading performance.
Donchian Channel Scalping
Scalping is a trading style that seeks to profit from small price changes. Scalping a trade requires quick and strict entries and exit plans. A Donchian channel strategy with scalping is used to make small profits when a stock moves above the channel high: You buy the asset on the breakout, then quickly sell it after it moves higher. You can also scalp by playing reversals off the upper and lower channels.
Donchian Channel Breakout
A Donchian channel breakout trading strategy is used with trend-following plays. Traders can establish a long position when the security is above the channel high and go short an asset when it is below the channel low. A Donchian channel breakout strategy is often used when there is an existing price trend. Stock trading and derivatives trading can employ Donchian channel breakouts.
Reversal Trading Strategy
Traders also use a Donchian channel strategy to help spot reversals. When a stock price falls below the center line, a short position might be initiated to wager on continued weakness.
On the flip side, when a stock rises above the center line, a long position might be made with the hope that the price continues higher. With reversal trading, the position is closed when the price hits the channel low or high.
Pullback Trading Strategy
The pullback strategy is usually very short-term in nature. If you notice that price continues to touch the channel high before falling back, then shorting an asset when it hits the channel high is a viable pullback strategy.
If the security touches the channel low repeatedly, then bounces, going long that stock in a broader uptrend can help you “buy the dip.”
Donchian Channel With Futures
Richard Donchian, dubbed the father of trend following, developed this indicator in the 1950s and originally applied it to commodities trading. Hence, trading futures contracts with the Donchian channel indicator is common practice.
Donchian created this tool as a trend-following indicator. So, it helps to use it on commodities (or other futures products) that are in an existing uptrend or downtrend. A trendless chart can lead to many false signals.
Other strategies can be used to profit from sideways price action including strangling an option.
Donchian Channel vs Bollinger Bands
While a Donchian channel is plotted with the highest and lowest price over n-period along with an average line, Bollinger Bands uses a simple moving average, then applies a two standard deviation upper band and a two standard deviation lower band.
There are key differences between a Donchian channel vs. Bollinger Bands.
|Uses price highs and lows to mark a channel
|Uses dispersion to mark trading bands
|Identifies potential new trends
|Spots potential trend reversals
|Heavily influenced by price extremes
|More balanced since a simple moving average is used
Donchian Channels Limits
There are some limits with Donchian channels.
In assets with low floats, where a large proportion of the asset is held by insiders or institutions, channel trading can be ineffective. Low floats tend to correlate with high volatility, therefore, prices can fluctuate to such an extent that channels become less effective indicators.
Calculating Donchian Channels
Calculating the upper limit, lower limit, and center line to form a Donchian channel is straightforward. The below calculations assume a 20-day period.
Channel high line: 20-day high
Channel low line: 20-day low
Center line: (20-day high + 20-day low)/2
The channel high is seen as the limit of bullish energy as it is the highest price recorded over the period used. Traders use the Donchian channel high as an indicator to go long a stock based on bullish price momentum.
Stocks breaking out through the channel high are seen as establishing a new upward trend or continuing existing upside price action.
The channel low is the lowest price hit over the period. Stocks that break down below this line are sometimes used as candidates to sell short with a Donchian channel strategy.
The center line identifies the average price over the period. It is the middle ground of price action and is sometimes seen as a mean reversion price.
Example of Using Donchian Channels
To illustrate Donchian channels, here is a one-year stock price chart with Donchian channels plotted. The standard 20-day period (closing prices) is used.
Donchian channels can be used with other indicators to form strategies with many types of investments.
One strategy is to combine a Donchian channel with the MACD indicator.
Another strategy uses a volume oscillator with Donchian channels to help confirm a breakout or breakdown.
Finally, a Donchian channel can be used alongside a stochastic oscillator and moving average to help find buy and sell points.
Donchian channels can also be used with options trading: learn more about options vs. stocks.
Using a Donchian channel strategy is just one way to analyze a stock. It is a technical analysis indicator that helps you identify breakouts, reversals, and potential overbought/oversold conditions.
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Photo credit: iStock/ArLawKa AungTun
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