What is the Donchian Channel indicator?
The Donchian channel is a market indicator, created by Richard Donchian. It is based on calculating the lowest low and the highest high of the market for the last nth periods. The channel is the area between low and high for the chosen time period.
It is a common tool that is available on most trading platforms. It is depicted in the form of a chart with a line demonstrating the market price channel for high and low values. It is a productive tool to measure the volatility of the market.
The Donchian Channel Explained in Detail
The Donchian channel has a default setting of a 20-days period which can be adjusted by the traders. Based on the default setting, it can be classified into 3 parts:
- The 20-day high, known as the upper band
- The average of the upper and the lower band, known as the middle band
- The 20-day low, known as the lower band
If you will look at some of the examples of the Donchian channel, you will realize that it is not extremely tough to understand. If the Donchian channel indicator is narrow, the price is stable. It will be wider if there are a lot of fluctuations. It is primarily used for providing long and short forex position signals.
How to Use the Donchian Channel for Maximum Benefits?
To begin with this part, you first need to understand with ‘R’ stand for. ‘R’ denotes the relationship between the risk that you are taking and the relative return. For example, if you are risking $20 and earning $1000, you have gained 5 times which is denoted at 5R.
Understanding the Donchian channel might not be rocket science but it does require your utmost attention. While any trader is bound to make a few mistakes while using it for the first time, here are some pro-tips on how you can use this tool to maximize your profits:
- 2R open profits
It is necessary to create a safety buffer because you never know when the market might go against you and there is a pullback. If you trade without open profits, you may lose more than what you had assumed earlier.
- Scale your winner with respect to the pullback
The Donchian channel breakout can be used as an entry trigger. It is would be unwise to risk 1R on your later trades as you stand to lose all open profits if the market pullbacks. You need to adjust keeping in mind the risk factors involved. Go in with 0.5R instead so that you still have a good chance of making a larger profit if there is a movement in the market in your favor but with reduced risk.
- Know when to exit
This applies to every trade and business. One must have an exit strategy. How will you exit from your position? Will you exit both long and short positions at the same time and restart again or will you make a different strategy?
These are the things that you must decide even before you begin a trade.
How to Customize the Donchian Channel for Better Trades?
The upper and the lower band of the Donchian channel are the most versatile ones. You can adjust them and not the middle one as that shows the average of the other two. Use the extreme bands as trend filters to get an idea of whether you should be selling or buying.
This is how it is done:
- Define the long-term trends by adjusting the channel to 200-period.
- There are buying opportunities if the prices are rising above the middle band.
- There are selling opportunities if the prices are falling below the middle band.
How to Use the Dochian Channel to Identify the Latest Trends
If used properly, the Donchian channel can allow you to identify the massive trends of the market. These trends can keep you way ahead in the game If you want to ride these massive trends, you should trail your stop loss.
What does this mean?
Trailing the stop loss means that you will stay engaged in the trade. You will neither have target profits nor will you second guess yourself. You cannot bail out because the situation doesn’t feel comfortable.
You will not abandon your trailing stop loss and exit when the channel signals that to you.
This is how the Donchian channel can help you in riding big trends
- Traders should use the lower band of 20-days (low) for trailing your stop loss if you wish to ride an uptrend.
- Traders should use the upper band of 20-days (high) for trailing your stop loss if you wish to ride a downtrend.
Whether you wish to ride the shorter or the longer trends, all you have do is to adjust the Donchain channel settings. To ride a long term trend, opt for a higher value, and to ride a short term trend, opt for a lower value.
The Donchian Channel and the Average True Range Combo
The Donchian channel and average true range combo can allow traders to find highly profitable trades consistently. This is not a magical combo that comes with guaranteed success but it can help you in predicting when the market is expected to have an explosive breakout. Here’s how:
You need to study multi-year low levels by using the Average True Range indicator (ATR). If it is lower than the previous multi-year low, it is a good sign.
You need to trade using the breakout of the Dochian channel forex. You go a long position when the price breaks above the upper band and short position when the price breaks below the lower band. The upper band is 20-week high and the lower-band its 20-week low.
This is done because the market has a way of movement. It goes from low volatility towards high volatility. The ATR indicators will allow you to detect low volatility periods and the Donchian Channel will enable you to trade with breakout and capture the move.
Mistakes to Avoid when Trading Using the Donchian Channel
As we have mentioned earlier as well, this channel does not translate into 100% success. It is a tool that can be profitable if used ride. It can show you the trade opportunities and the current market trend but it will not take the decisions on your behalf or freeze the market for you. Many traders blindly trade the bands and take everything at the face value. They go short when they see the price is at the upper band. They assume that the market will reverse slowly as it is overbought at the moment. This is the first mistake that you can make. This is because it is an uptrend and in such situations, the prices tend to remain in the upper band for a long time.
So what does this mean?
It means that use the Donchian channel for its intended purpose, that is, you should let it guide you regarding your entries and exits. It is not the right indicator to assess whether the market conditions and overbought or oversold.
Veteran and regular traders are familiar with the terms related to the Donchian channel and how it should be used. However, if you are a new trader, you must have a few questions. Let’s answer them:
Q1. Does the price break out in the Donchain channel? I can see the price touching the top or the bottom channels. The channel adjusts to the price changes afterward. This does not look like a breakout. Can you explain this?
A. Consider a situation in which you have set the channel for a 50-day high of the market. If the channel touches that upper blue line, it indicates that the prices have broken out of the 50-day high. Similarly, if the prices touch the lower blue line, the prices have broken from the 50-day low.
Q2. Can you explain how the Bollinger Bands are different from the Donchian channel?
A. These two are very different tools. Bollinger Bands adjusts itself according to the volatility of the market whereas the Donchian channel is about the highs and lows of the market. It plots the highs and the lows of the market for the period that you have set.
The Donchian channel can help you to understand the highs and lows of the market. This means that you can easily determine the current or the upcoming trends and ride them to make profits. It is not meant to identify whether the market is overbought or not. You can look for price breakouts and make the trade based on your understanding. It is a marketing tool and not and handbook. This must be kept in mind at all times.