- July 26, 2019
- Posted by: CoachShane
- Categories: Trading Article, Trading Indicators
Donchian channels, brought to us by Richard Donchian (1905-1993), is a great trading indicator to highlight trends, ranges, and new X number of day breakouts.
You can design many trading strategies around the Donchian channel and it was the primary indicator for the Turtle Traders.
The channel works by highlighting the highest high or lowest low of the prior 20 days. Note that the number of days for the channel settings can be changed.
Reading the channel is straightforward:
- Upper band is the highest high of the past 20 days
- Lower band is the lowest low of the past 20 days
- Middle line is a moving average that calculates the average of the previous 20 day low/high
On this stock chart of Aurora Cannabis, you can see how the Donchian channel clearly shows the current 20 day high. You can also see that the low was in place for 13 days before new lows in price are currently being made.
The moving average in the middle and the contraction of the channel shows a market that was in a range. The turn down in the moving average and the widening of the channel can indicate trending action taking place.
How To Trade With Donchian Channels
The strategies you are about to learn can be used on any time frame however all the examples are from the daily chart.
Daily charts are where I trade which keeps me out of the day trading noise of all markets including futures. I also find that the daily charts give me the cleanest setups and triggers that I prefer to trade.
I recently covered one Donchian channel trading strategy in a post called Turtle Soup where you don’t trade the breakout direction. You fade the move. It is a simple breakout failure trading strategy that is simple to set up and scan for.
Trading with the trend is a time tested strategy for any style of trading – day trading, swing trading, position trading.
We can use Donchian channel breakouts in line with the longer term trend to make good gains in our trading account if we catch a persistent trend direction.
Trend Trading Breakouts – Donchian Channel + ADX + SMA
We will use the following for this strategy:
- 20 period Donchian channel
- 100 day simple moving average for a trend filter
- ADX setting of 25
Our basic trading rules are simple:
- Is the ADX above 25? Yes – continue No – stand aside
- Price above 100 SMA? Yes – longs – No – shorts
- Breakout in direction of 100 SMA? – Yes – trade signal No – stand aside
On this chart, we see that for much of the chart, the ADX was below 25. We would ignore this chart during this time.
Once ADX starts moving above 25, we are interested in what price does next. In our case, price went below the 100 SMA allowing us to short breakouts to the downside.
The Forex pair is up over 400 pips from the breakout point noted at the red line.
Donchian Channel + RSI Trading Strategy
This strategy also uses the trend direction but this time from the RSI 50 level
- RSI +50 is bullish
- RSI – 50 is bearish
We can trade both pullbacks as well as breakouts in the direction the RSI determines is the trend direction. I will treat the pullbacks to the moving average as bull flags/bear flags and be mindful of trading ranges.
You can learn more about trading bull flags here: Trading Bull Flags.
The is the 10 Yr T Notes futures daily chart and we have several great events here.
- Pullback to the moving average that is a complex correction. Break of trend line to the upside while RSI is above 50, is an enter near the close or the next days open
- The Donchian channel has compressed and see a ranging market. While there are range trading strategies, we sit aside
- RSI begins to climb and we have a new 20 day breakout.
- Price pulls back again and fails into a range as RSI dips below 50. No breakout to the downside.
- RSI rises and new 20 day high is made. This is a trade
- Pullback to the middle band and price breaks the trend line for the entry
Stops can be below support or above resistance for any trade. I prefer using the average true range for stop loss placement and adjusting around close swing points.
Profit targets can be a multiple of the risk, support or resistance levels, or using another Donchian channel.
Exiting Trades With Donchian Channels
For this add-on strategy, we will use 2 channels with different settings.
- Use the original 20 day setting
- Use the 10 day setting and remove middle moving average
In this case, we are using an objective way to take our trading profits by using a break of the 10 period Donchian channel as our signal to exit.
Notice at point 1,2, and 3, that we have our entry part of the strategy all confirmed.
- ADX is above 25 indicating a trend
- Price is below the 100 simple moving average telling us the trend direction is down
- Price makes a new 20 day low and we are short
The trade is allowed to run and we are using the red line, the 10 day channel, as a means of trailing our stop loss level.
The small green arrow and the check mark shows where price finally breaks the 10 day high which ends the trade. This particular short trade in crude oil futures dropped $15 in price banking some hefty trading profits.
Things You Must Know
As with any trading indicator or strategy, you will have false signals and the Donchian channel is no exception.
We can mitigate these to some extent by:
- Trading with the trend direction
- Needing a close for the new high
- Using other price patterns like triangles and bull/bear flags
Nothing is perfect which is why risk management is vital to any trading strategy.
Channels do not offer support and resistance levels. While they may highlight turning points in the market, there is no guarantee that you are looking at a level that will hold any importance in the future.
You must back-test any trading plan that includes Donchian channels. You must have a set of rules, including markets you will trade, and test those out with your trading parameters.
The strategies here are meant as starting points for your strategy development. Any price channel strategy has the bonus of giving you a reference point for price. Channels are one of my favorite approaches to trading.