Abstract：Price movements in currency markets can be hard to predict, but they are not entirely random.
There is a logic behind the way currencies rise or fall in value, and decades of forex trading show that this logic can often be identified and then predicted using technical indicators. Undoubtedly, Donchian Channel indicator belongs to one of them.
Today, we are going to talk about Donchian Channel indicator, a channel-based technical analysis trading strategy used as an indicator for trading in financial markets. We will discuss the definition and calculation of Donchian Channels, and how to trade and combine them with other indicators.
What are Donchian Channels？
Richard Donchian developed a moving channel trading strategy in the early 1970s, which was named after him–the Donchian Channel.
The Donchian Channel indicator makes use of candlestick charts, as data is clearly shown and mapped, which helps in decision-making according to signals detected.
The Donchian Channels indicator comprises three lines that help show price volatility, trend breakouts, reversals, and potential overbought/oversold market conditions. It consists of three separate bands generated by moving average calculations. The central part of the indicator is the mid-range band(or average band). You also have the lower and upper bands on the outside. The upper one shows the highest price of an asset, while the lower one represents the lowest price. The band in the middle is simply the average of the other two. You calculate the value over a specific number of periods you define. The chart below shows a daily chart of the EUR/USD pair with a 20-day Donchian channels.
Ideally, if there is substantial volatility in a certain period, the Donchian Channels will be substantially wide. Similarly, if there is minimal volatility in a certain period, the Donchian channels will be relatively narrow.
Traders use the indicator to measure volatility and identify potential breakouts and reversal areas.
Donchian Channel Calculation
Donchian Channels are one of the more straightforward indicators to calculate and understand. The indicator simply takes a user defined number of periods and calculates the Upper and Lower Bands. The calculation is as follows:
Upper band: Highest price in prior n periods
Lower band: Lowest price in prior n periods
Average band: (Upper band + Lower band)/2
n can be a different period length depending on the measurement time frame under study – such as minutes, hours, days, weeks, or months – and the period will be the number of periods being measured (e.g., 30 minutes, 24 hours, 20 days, 1 week, or 6 months).
Typical Donchian Channels use a 20-day trading period, which is the average number of trading days in a month. For the above example, a 20 day period is used which is a very commonly used timeframe.
Upper Channel = 20 Day High
Lower Channel = 20 Day Low
Average Channel = (20 Day High + 20 Day Low)/2
What Do Donchian Channels Tell You？
Donchian Channels identify comparative relationships between the current price and trading ranges over predetermined periods. Three values build a visual map of price over time, similarly to Bollinger Bands, indicating the extent of bullishness and bearishness for the chosen period. The upper band identifies the extent of bullish energy, highlighting the highest price achieved for the period through the bull-bear conflict.
The average band identifies the median or mean reversion price for the period, highlighting the middle ground achieved for the period through the bull-bear conflict. The lower band identifies the extent of bearish energy, highlighting the lowest price achieved for the period through the bull-bear conflict.
If the price reaches the upper band, you have an overbought signal. If it touches the lower one, the market condition is considered oversold. However, you should bear in mind that such scenarios are pretty standard. This means most of the generated signals aren't informative on their own.
How to Trade Donchian Channel Indicator？
Here is how to effectively trade the signals generated by the Donchian Channel indicator.
#Trading Breakouts
This is the primary use of the Donchian Channel indicator. Many traders will use the average band of the Donchian channel as an indicator of when to open or close a position. Generally, if the price moves above the average band, traders will open a long position; if the price moves below the average band, traders will open a short position.
In other words, when the price touches the upper or lower bands, it simply means that the asset price is trading at its highs or lows for the last n periods. If it touches the upper band, that is a signal that a bullish breakout has occurred and traders should place buy orders. Likewise, if it touches the lower band, traders should seek to place to take advantage of a bearish breakout. However, it is important to wait for two consecutive candles to touch of the outer bands to qualify a tradable breakout.
#Trading Pullbacks
This is a strategy to pick out the most optimal entry points in a trending market. When prices are trending, the most lucrative entry point is when a pullback occurs. This is where the average band comes in. For instance, when prices are trending higher in an upward sloping Donchian Channel, the most optimal price to place a buy order is when the price bounces off the average band.
#Trading Reversals
This is a short-term strategy and isnt indicative of the long-term direction of the trend. The average band can also be used to qualify trend reversals in the market. This can help traders exit previous trades and also enter early on a new trend. For instance, if you had an active sell order when the Donchian Channel is sloping downwards, an upward breakout of the average band would be a signal to exit the trade. It will also be a signal that buy orders can now be placed, with the first price target being the upper band and beyond.
This strategy is convenient for picking out the optimal entry points when the market is trending. The reason is that when the price is trending, the most fruitful moment to open your position usually is right after a pullback occurs.
When combined with an oscillator like the RSI, Donchian Channels has proven effective in ranging markets. That way, you can get a more precise indication of whether the market is really overbought or oversold.
Combine Donchian Channels with Other Indicators
Donchian Channels offer an easy-to-interpret map of volatility and trading price history, which helps visualize the price action and confirm other indicators' signals even though they won't grant actionable new information. Therefore, Donchian Channels work best when there is a clearly defined trend and when trading on longer-term charts.
It is very efficient when combined with other technical analysis tools such as trend lines, Directional Movement Indicator (DMI), Relative Strength Index (RSI), Average Directional Index (ADX), and other tools.
The way you will use the Donchian Channels indicator depends on your broader strategy. For example, you can use a directional strategy to rely on higher volatility to generate more trading signals and buy/sell opportunities. You can also use it if you rely on range-bound price movements when the market is calmer.
Conclusion
Many traders believe that when the market price hits the upper channel, it will reverse, and when the price hits the lower channel, it is suitable to go long. But this is often a mistake, because markets don't usually react the way you think they do. The Doncian channel is suitable for use in trending markets and can be combined with other indicators to increase the accuracy of trades.
