Donchian channel is a well-known indicator thanks to the infamous Turtle traders. This indicator is particularly helpful for identifying the entry and exit points in trends, especially for trending markets. Let’s explore how Donchian channel indicator can be used for making better trades.
What is Donchian channel indicator?
Developed by Richard Donchian, Donchian channel is one of the simpler technical indicators. The main purpose of this indicator is to enter the trend on a breakout and to ride the trend for as long as possible, avoiding shakeouts.
The indicator consists of mainly two bands – an upper resistance band and a lower support band.
- The upper band is calculated as the highest high price for the selected ‘n’ period.
- The lower band is calculated as the lowest low price for the selected ‘n’ period.
- There is also a middle band which is the average of the two bands.
i.e, (Upper Band + Lower Band) / 2.
Usually, 20-period is the default trading setting of Donchian Channels. But this value can be tweaked depending on your trading style. The figure below shows a Donchian channel indicator.
Donchian channel indicator and Volatility
Donchian channel indicator can be used for identifying market volatility.
- When there are high volatility and heavy price fluctuations, Donchian channels are wider
- When there is lower volatility and prices are relatively flat, Donchian channels are narrower.
How Traders Use Donchian channel indicator
There are clear bullish and bearish signals given by Donchian channel indicator which are used by traders for making better trades.
- Traders go long when price crosses the upper Donchian Channel
- If the stock rises above the middle band of the Donchian channels, traders go long.
- During a clear uptrend, when the price pulls back to the lower band, traders go long.
- Traders go short when price crosses the lower Donchian Channel.
- If the stock falls below the middle band of the Donchian channels, traders go short.
- During a clear downtrend, when the price rises to the upper band, traders go short.
The figure below shows how to use Donchian Channel indicator or buying and selling.
Donchian channel indicator and Buy/ Sell Signals Using Two Sets of Channels
One of the trading strategies used by expert traders is to use two different periods of Donchian Channels for entry and exit. For instance, 20-period Donchian Channel and 15-period Donchian Channel.
- When the price moves above the upper band of the 20-period Donchian channel, traders buy the stock. Then they exit the trade when the price moves below the lower band of the 15-period Donchian channel.
- When the price moves below the lower band of the 20-period Donchian channel, traders short sell the stock. Then they exit the trade when the price moves above the upper band of the 15-period Donchian channel.
In addition to the above strategy, traders use Donchian Channel in combination with the MACD indicator for filtering out the false entry signals. Another strategy is to use the 25-Day/350-Day EMA (exponential moving average) as a trend filter. These traders choose long positions only if the 25-Day EMA is above the 350-Day EMA. Similarly, short positions are chosen only once the 25-day EMA is below the 350-Day EMA.