A trader's guide to Donchian channels
Donchian channels are a technical indicator developed by Richard Donchian – a famous commodities and futures trader. Here we explain what Donchian channels are, how to calculate them and how to use them in your trading.
What are Donchian channels?
Donchian channels – as the name suggests – are a channel trading indicator which traders use to identify potential breakouts and retracements. Donchian channels are usually used with candlestick charts, rather than line graphs, so that the information supplied by the channel can be clearly mapped, and any subsequent trading signals can be acted on quickly.
Learn more about candlestick trading
This is because candlesticks can clearly show the open, high, close and low of a trading session, which is crucial information in determining the accuracy of Donchian channel forecasts. The channel itself is made up of an upper band and a lower band, set either side of an average of the two in the middle.
The price graph below gives an example of what Donchian channels look like when set over a candlestick chart.
How do Donchian channels work?
Donchian channels work because three bands show the current market momentum. The upper band represents the highest high of the previous period, the lower band represents the lowest low of the previous period, and the middle band represents an average of the current high and the current low for that trading period.
Traders will use Donchian channels to map the momentum in an underlying market, and they will use the signals supplied by the channel to open either a long or a short position at any given time.
If an asset is trading around the middle line with no strong deviations toward the upper or lower band, then the market is currently experiencing low volatility and there might not be a clear overall bullish or bearish trend.
But, if the market is trending towards the upper band, traders might use this information to open a long position and profit from the market rising in value. If the market’s momentum is currently trending towards the lower band, a trader would do the opposite and open a short position to profit from the market falling in value.
How to calculate Donchian channels
To calculate Donchian channels, you need to learn how to calculate the upper band, the lower band and the middle line separately. This is not normally necessary because most trading platforms – including the IG trading platform – will calculate Donchian channels for you at the click of a button. However, should you wish to calculate the bands yourself, you can do so using this formula:
- Upper band: highest high in previous n periods
- Lower band: lowest low in previous n periods
- Middle line: ((upper band – lower band)) ÷ 2)
In this equation, n is taken as minutes, hours, days or months, depending on what timeframe you prefer to calculate the Donchian channel for. Periods refers to the number of timeframes used in n. Most traders will use 20 days as their reference point to calculate Donchian channels.
How to trade using Donchian channels
Many traders will use the middle line of the Donchian channel as an indicator of when to open or close a position. Generally, if the price moves above the middle line, traders will open a long position; if the price moves below the middle line, traders will open a short position.
Traders will maintain a long position until the asset’s price hits the upper band. Once it does so, they have a choice to make. If the price hits the upper band but does not break through – known as a breakout – many traders will choose to close their long positions and open a short position on the expectation that the bullish trend will reverse and turn bearish back towards the middle line.
But, if the price breaks though the upper band then this could signal a bullish rally, in which an asset’s price could continue to climb for a period. In this case, many traders will keep their long positions open. Traders will usually only do this if the asset is closing above the upper band consistently in order to avoid the possibility of trading a false breakout. When trading with Donchian channels, stop orders – such as guaranteed stops – can help to protect a position against any bearish reversals against the prevailing bullish trend.
Alternatively, traders could use trade the Donchian channel during a bearish trend. Again, they would do this by opening a short position once the asset’s price has crossed from above the middle line to below it.
Traders will hold their short positions until the asset’s price drops to the lower band, at which point they would again have a choice to make. If the price hit the lower band but did not close below it, it could be a sign that they should close their short position on the expectation that the asset’s price is about to reverse from bearish to bullish. In this scenario, a trader might choose to open a long position.
However, if the asset’s price closed below the lower band, a trader might choose to keep their short position open in order to capitalise on a possible bearish rally. In order to prevent themselves from a false breakout, many speculators will wait until the price has closed at least twice below the lower band, and they could well use a stop on their short position to protect themselves against possible bullish reversals.
Donchian channels trading strategies
Donchian channels can be incorporated into a range of trading strategies, but they are most effective in breakout trading, reversal trading and trend trading strategies.
In a breakout trading strategy, a trader will attempt to enter a trend as early as possible in anticipation that the underlying asset will ‘breakout’ of its current trading range. Breakout trading is most effective in the short to medium term.
A reversal trading strategy is one in which a trader will wait for the overall trend to reverse from bullish to bearish, or from bearish to bullish.
Follow the steps below to start trading with Donchian channels:
Donchian channels summed up
- Donchian channels are a trend trading channel indicator
- They use an upper and lower band, set either side of a middle line, to identify bearish and bullish rallies, or bearish and bullish reversals
- The upper band is calculated from the highest high in the last n periods
- The lower band is calculated from the lowest low in the last n periods
- The middle line is taken as an average of the current upper band and the current lower band
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