3 Simple Donchian Channel Trading Strategies
What are Donchian Channels?
Richard Donchian created Donchian Channels, which is a type of moving average indicator and a look alike of other support and resistance trading indicators like Bollinger Bands. However, Donchian Channels has a simple plotting of highest high and lowest low of the last “n” periods. The n periods is based on the trader’s choice, who can select the period according to their requirements ranging from a day, hour and minutes etc. Traders use Donchian Channels to understand the support and resistance levels.
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Isn’t it a very simple calculation as compared to Fibonacci?
Let’s dig further into how Donchian Channels are used…..
Donchian Channels usage in Trading
Donchian Channels is a popular indicator for determining volatility in market prices.
Donchian channels are wider when there are heavy price fluctuations and narrow when prices are relatively flat. Generally, investors use 20-periods with the Donchian Channels as the default trading setting, but this value can be tweaked based on your trading style.
Now, let’s take a look at the below image to illustrate Donchian Channels. Since Donchian Channels are primarily used to determine volatility, we have accordingly selected the velocity Shares 3X Inverse Crude ETN linked to the S&P GSCI Crude Oil Index Excess Return(NYSEARCA:DWTI). We have selected these securities due to the recent oil price fluctuations in the market. We have taken the default DC (20) setting in the chart and selected “day” for the time period.
In the below image, you can see that the wider price range is highlighted in blue while the narrow price range is in yellow.
Donchian channels are mainly used to identify the breakout of a stock or any traded entity enabling traders to take either long or short positions. Traders can take a long position, if the stock is trading higher than the Donchian channels “n” period and book their profits/short the stock if it is trading below the DC channels “n” period.
Let’s identify buy/short positions by taking an example of Apple stock and applying the Donchian channels strategy. We have taken a 1-hour chart covering Apple stock’s movement from April 20th, 2016 to June 23rd, 2016. As you see, we placed our Donchian channels indicator on the existing trend which is visible on the left side of the image.
Now, in the below image you can see that we have highlighted major breakouts. At the extreme left of the chart, on the lower side, we have identified a price breakout of a downward trend, signaling traders to open a short position or liquidate long positions. Hence, we open a short position at $106.67 on April 20th. Accordingly, the stock had a sharp correction after a few days.
Donchian channels again indicated a buy back position during the mid-week of May 2016. We cover our short position at $94 on May 16th, which resulted in over $12.67 profit per share.
Meanwhile, we have also identified the price breakout on the lower side of the channel, indicating the start of the new downtrend in the stock. We have highlighted this in blue in the below image.
Also, note that you need to confirm the uptrend or downtrend, with two consecutive touchpoints of the Donchian channel before pulling the trigger on a trade.
For instance, if we look at the same Apple chart below, we have highlighted where there are two consecutive price increases/decreases confirming our buy/sell trends with Donchian channels.
Trading with the Middle Band
The middle band is the average of the upper and lower bands. The middle band in Donchian channels could also be used as a breakout indicator. If the stock rises above the middle band of the Donchian channels, than you can open a long position. On the contrary, if the stock is trading below the middle band of the Donchian channel, then a trader can open a short position.
For the below chart, we have identified buy and sell positions for Apple, based on the Donchian channels middle band. We have highlighted in orange short/sell positions and
Buy/Long positions in blue.
Three Simple Donchian Channel Trading Strategies
Now, let’s have a look at a few Donchian Channel trading strategies, which can be incorporated into your current trading methodologies.
Combining Donchian Channel trading strategies with other trading strategies might decrease the false entry/exit signals and give a clearer picture on trading opportunities.
Donchian Channel + MACD
Let’s combine the Donchian Channel trading strategies with the commonly used MACD. Here let’s try to match the moments when the price interacts with important Donchian Channel entry points in conjunction with MACD crosses.
When we discover this correlation between Donchian Channel and MACD, we would be able to filter the false entry signals and attain a better success rate for our trade opportunities.
Let’s have a look at the below 30-minute chart for Microsoft from May 13th to June 23rd, 2016.
Here we have identified a buy signal for Microsoft at $51 from the Donchian Channel as well as MACD on May 24th.
We received a sell signal from MACD on the following day, and at this point, the stock had already risen to $52.40, giving traders a profit of over $1.4 per share. This is definitely a lucrative return in the span of two days.
Donchian Channel + Volume Oscillator
Let’s have a look at Randgold Resources Ltd. (ADR) (NASDAQ:GOLD) chart from May 9th, 2016 to June 23rd, 2016. The stock had a wide trading range in the two months given fluctuating gold prices. We have selected the default Donchian Channel (20) and Volume Oscillator for this period.
We have identified a buy opportunity at the upper band as per the Donchian Channel on May 31st at $85.07. At the same time, the Volume Oscillator started rising and crossed above zero indicating strong volumes at these levels. We have highlighted the buy opportunity in violet for both indicators.
After initially trading flat, the stock delivered outstanding returns for a number of days before indicating a sell signal on June 10th, and this trend was supported by the Volume Oscillator, which was heading below zero while prices were falling. We have identified the sell position in red for both the trading strategies in the below image.
By the time we receive the sell signal, the stock had already generated strong returns topping out over $94.28 on June 10th. This would have resulted in over $9.21 per share returns in a span of one week.
Wow! Isn’t it attractive?
Donchian Channel + Stochastic Oscillator+ Moving Average
Lastly, we are going to cover a trading strategy with the Stochastic Oscillator and Moving Average.
We have taken an Amazon chart from May 22nd, 2016 to June 24th, 2016. Let’s take a look on how we have applied these three indicators to establish a trading position.
First, we have a buy signal from the Donchian Channel on May 2nd, 2016.
Next, we have a buy from the Stochastic Oscillator within three days on May 5th.
With the stock price breaking out above the moving average on May 6th, the bullish trend is confirmed. Accordingly, we open a long position slightly above $669.
Consequently, the stock rallied for over a week post May 9th touching more than $720.
The stock prices started consolidating and we received our sell signal from the Donchian Channel on May 17th. In addition, the stock was trading below the moving average indicator as well and the stochastic oscillator gave an overbought signal.
This trade generated us a profit of $31 per share in a span of just two weeks.
- Donchian Channels are a type of moving average indicator
- Donchian Channels indicate the support/ resistance levels of a security
- Donchian Channels is used primarily to determine volatility
- Donchian Channels upper band is used for identifying long/buy positions
- Donchian Channels lower band is used for identifying short/sell positions
- Donchian Channels can be used as a breakout indicators by traders
- Donchian Channels middle band is the average of upper and lower bands and could also be used as a breakout indicator
- Traders need to confirm a trend with two consecutive touches instead of only one, before taking a position
- Donchian Channels usage along with other indicators can reduce the number of false trading signals
- A few simple trading strategies using the Donchian Channels are:
- Donchian Channel + MACD
- Donchian Channel + Volume Oscillator
- Donchian Channel + Stochastic Oscillator+ Moving Average