Technical analysis indicators are used throughout the markets to help traders better understand its movements and decide what strategies they should implement. They can be used to identify upcoming trends, to better understand a previous completed transactional period, or even just to scrutinize the daily movements in an isolated market. Some of these indicators revolve solely around momentum, or at least the factors that shape it, while others focus on volatility and its associated markers. However, a relatively simple multipurpose tool exists that incorporates a number of the aforementioned aspects: the Donchian Channel.
What Is a Donchian Channel?
Created in 1936 by career futures trader Richard Donchian, the Donchian channel plots high and low asset prices over a set period, using candlestick markers to separate small sections of that timescale. Candlesticks, so named because of their distinctive shape, are used as graphical indicators on market analysis charts to show the high, low, opening, and closing prices of a security. Donchian channels are commonly used to help analysts highlight trends as well as ranging periods (the difference between an asset’s high and low price within a given timeframe) for intraday trading.
Additionally, Donchian channels offer the option to plot a third line between the high and low lines mentioned previously, called a mid-band (the high/low lines are called “channel lines”). This mid-band is determined by calculating the average of the channel lines surrounding it. Donchian channels are extremely useful for day traders, as they work well on all timeframes (such as 1-minute/10-minute charts, where a new marker forms every 1 or 10 minutes) and can be applied to any form of financial market. Traditionally, analysts have used Donchian channels to help them identify and capitalize on breakout positions — these being markers that denote a price moving through a previous high or low to create an intraday lower low or higher high.
What Is a Donchian Channel Backtest?
Interestingly, when calculating Donchian channels one does not include the current price bar. This means that, should an investor choose to apply the indicator to a graphic that includes 10 candlesticks, the bands are plotted and determined based on the price action of the previous 10 candlesticks. This method is called backtesting, which is a term applied to the act of simulating how well a strategy or set model will perform after the fact by using pre-existing data. Backtesting can be easily carried out on platforms such as TradingView. It is using this method that Donchian channels are calculated.
Donchian Channel Formula
A trader is using a 2-minute chart and the high price marker on that chart over the last 30 minutes shows that stock was trading at a high of $55.50. The lowest price in that same period was $45.50, meaning that the low/high channel lines will be drawn at $55.50 and $45.50, respectively. The mid-band, if used, would therefore sit at a round $50.00.
What Is Donchian Channel Strategy?
Traders use Donchian channels to determine the comparative relationships between a current price and its trading ranges through a select timeframe. The three values mentioned previously help to build a literal image of how a price performs over time and indicate the extent of the effect that bullish and bearish tendencies have had on that price. As one might expect, the high channel line shows the extent of bullish feeling toward the asset in question, while the low channel line shows the extent of the bearish attitude shown. This is a good indicator of momentum, allowing a trader to more easily identify overbought or oversold stocks/assets and securities.
However, it is also important to understand the potential limitations when using Donchian channels, since markets are prone to move through many cycles of activity. Just because a set time period is in common usage does not mean it will accurately reflect the current/future conditions of the market in the way a trader would want — something that if believed can lead to indicators generating false signals. This can damage trading and investment performance, or at the very least limit market capitalization.
Combining Donchian channel strategies together with other trading strategies can decrease the likelihood of these false entry/exit signals, allowing traders to form a more accurate image of future trading opportunities. Here, we discuss a few combinations of note:
- Donchian channel + MACD: By combining a Donchian channel with an MACD indicator, a trader can match moments of price interaction. This will usually take place in the form of Donchian channel entry points intersecting with MACD crosses (one of the markers used on an MACD indicator). This allows analysts to eliminate false negatives/positives by removing the non-correlating data and attain a better chance of success when moving on trade opportunities.
- Donchian channel + volume oscillator: Again, these two common indicators are used in conjunction to try and identify corresponding data points, where the two forms of analysis agree upon a given price movement or future trend. Upon discovering areas where an upper channel line and an upwards oscillation correlate, traders can interpret this as a sign to trade bullishly and buy in on the specified asset/security.
- Donchian channel + stochastic oscillator + moving average: This strategy sees investors combining a Donchian channel with another commonly used oscillator chart and a standard moving average (MA). By doing this, the investor has effectively given themselves an even more fail-safe approach, as it is only when buy/sell signals correlate across all data sets that they will choose to act bullishly or bearishly upon it. This essentially allows traders to come as close to confirming that a momentum indication is worth following up on as possible and is a strong trend indicator.
Donchian Channel vs Bollinger Bands
At first glance, Donchian channels and Bollinger Bands look almost identical and they may even be perceived as functioning in the same manner too. However, there is a key difference between them, which is one that results in Bollinger Bands being more complicated to calculate but also one that allows them to give more accurate feedback. The key difference lies here: While Donchian channels plot the highest price and lowest price over a dictated period, Bollinger Bands plot a simple moving average (SMA) for a certain period, plus or minus the standard deviation of that price over the same period, multiplied by 2.
What Is the History of Richard Donchian and Donchian Channels?
Richard Donchian’s parents originally migrated to the US from Armenia in 1885, a full twenty years before the great trader’s birth in 1905. The young Donchian boy was educated at the best schools his family could afford at the time as it was presumed that he would continue his familial line of work, his father’s rug business. However, it was not long before the young lad had distinguished himself and his linear path was disrupted by an affinity and understanding of all matters financial. Richard soon endeavored to become a trader and was soon enrolled in an internship, but this path was in itself disrupted by catastrophic global events, in the form of a World War.
After serving in World War II, Richard re-entered the world of finance resuming active trading during the 50s and 60s. Perhaps it was this environment that helped shape his trading ideologies. Mr. Donchian was, in essence and by definition, a conservative trader — one whose methods were based soundly upon finding the most guarded approach for market capitalization. Although Richard Donchian originally worked in stock market trade and analysis, he found later that his specialization lay in the world of security trade and specifically the trade of futures contracts.
While Richard developed Donchian channels early in his career, it was not until later in life that he discovered the true value inherent in this form of analysis. Richard’s intention was for his channels to be used as a form of trend identification system, allowing traders to come to grips with the idea of intraday momentum. He implemented this system during his time as a stock trader but it was not until he engaged in the futures market that his Donchian channels truly began to blossom into the bedrock of short-term price analysis that it is now. Today, Donchian channel application is one of the most common and effective methods of measuring momentum and identifying overbought or oversold assets/securities.
Donchian channels are similar in many ways to Bollinger Bands, both in terms of appearance and usage. Both can be used in multiple ways, making them highly versatile where other technical indicators are more specified (though also sometimes more accurate). As we have seen, in order to maximize effectiveness and accuracy, it is often a good strategy to use Donchian channels in combination with other technical indicators as this can give a clearer picture. However, there is a reason Donchian channels became and have remained a staple of the world of financial analysis. Their simplicity in application and their versatility in usage makes them one of the most accessible forms of price indicator available to brokers to this very day and they have remained that way for almost 75 years.