Donchian Channel Indicator

Modern trading leans toward complicated market analysis, using nonlinear technical indicators based complex mathematical formulas, elements of econometrics and relying on artificial intelligence.

However, despite the constant expansion of the indicators package pre-installed in trading terminals, moving averages and other elements of technical analysis, opened a century ago are still out there. The secret of "longevity" is simple – century old tools continue to bring traders money.

Trading theorists explain the efficiency of the "old formulas" in a quite simple way^ principles that form the price movement are still the same: demand, supply and psychology. Donchian channel is an indicator created on the basis of two constantly working "crowd instincts»:

• Overbought and oversold assets
• The psychology of placing stop-loss and take-profit orders

The indicator's history

Richard Donchian started working on the stock market at 27 years by accident, after reading the famous book "Reminiscences of a Stock Operator", deciding to get back the funds lost during the "Great Depression". Like many Americans in that time, Donchian's parents and later Richard himself, kept the savings in securities.

The future pioneer of trust management received an excellent economic education at Yale University, but was forced to sell carpets in his father's, an Armenian refugee, shop. Once on the stock exchange, Donchian chose the path of analyst and investment consultant, which led him to create the world's first futures trust fund.

Futures trading was quite different from investing in shares:

• High risk-capital invested in the contract was "multiplied" by the leverage, which greatly increases both profits and losses
• High volatility - securities usually have been growing in long term, unlike commodity futures with their multidirectional trends

Change of specialization and opening of the Futures, Inc. Fund., demanded the creation of a universal algorithm, which employees-traders, managing customer funds for automatically regulated risk management, adaptable to the current market, can be trained to use.

In 1970, after trying a lot of rules and control systems, Richard Donchian abandoned complex trading strategies and developed single channel, which later received the name of the author.

The principles of Donchian's channel drawing

The calculation of the price channel proposed by Richard Donchian is based on the construction of horizontal lines between the minimum and maximum reached by the asset's price over a certain period of time.

The author traded futures for a month, about 22 working days (on the weekends markets are closed). Therefore, Donchian used a period of 20 days.

The following figure illustrates the principle of defining and redrawing horizontal lines: the day maximum at point (1) determined the upper limit of the channel, which was kept "untouched" for 20 consecutive sessions. On the 21st day, the previous landmark "dropped out" and the limit shifted down to the level of the next historical maximum for 20 days at point (2).

Pay attention to the change of colors of the lower and upper border of the channel. The figure shows the ”advanced version" of the Donchian indicator with automatic trend highlighting:

• Red - the currency pair is falling
• Blue - the currency pair is growing

Similarly, there is a redrawing of the lower border of the channel, it defines a minimum of 20-day period (period), which after the shift on the 21st day is redrawn at the new lowest value. It is selected from 20 sessions, without taking into account the minimum value (1) that has already "fallen out" of this segment.

In addition to the "historical redrawing " for 20 sessions, both horizontal lines decrease and increase each time new extremes appear within the period. Look as "steps" the channel creates on the downtrend and the uptrend.

As can be seen on the figure, the advanced version supports for the display of numerical values of Donchian borders, for convenience of traders trading on the levels of the   these lines.

Classic trading strategy based on the signals of the Donchian indicator

The indicator was developed for a permanent stay in a position where the sale replaced the purchase, fixing profit (loss) by opening new, so-called reverse trade. The signal for a reversal or a new entry was the fact of "breakthrough" of the horizontal line.

Rules for opening purchase positions:

1. The horizontal line is redrawn above the maximum of the new, just closed candle.
2. The closing price is located above the previous stage of the upper limit of the channel.

The picture visually displays the conditions of purchase that have arisen on the marked candle.

Rules for opening a sale position:

1. The horizontal line is redrawn at the minimum of the current candle
2. The closing price is below the previous lower limit of the channel

Holding a position until the opposite signal occurs allows the trader to "catch" long-term trends, staying in the position for a long time and allowing the profit to "grow".

Indicator settings

In the classic version, the indicator settings window contains only timeframes for which the highs and lows are determined.

The author preferred the 20 days setting, because he traded on this timeframe. Modern traders use Donchian channels for different timeframes, so the selection of the interval is really wide:

• For hour candles, one can choose 8 hours or 24 hours timeframes
• For five minutes candles, equivalent of an hour - 12 candles, is the most common setting.

Advanced settings of the indicator can contain additional color signals, text information, trade marks, alerts, etc.

Psychological principles of Donchian's strategy

Richard Donchian exploited the principle of "the crowd mistakes". Most traders do not predict the trend correctly. So they set special orders that limit losses, called stop-loss.

The highs and lows of the current month – the most likely zone of accumulation of such orders. Almost every trader, regardless of the deposit volume and experience, believes that the price will break through this lines.

What happens when the price goes beyond the minimum/maximum? Lots of stop-losses, protective orders that open positions in the direction of the trend, are triggered. That is, to fix losses from the sale, the trader needs to purchase exactly the same volume and vice versa, sales fixes purchase losses. Thus, the trade made via Donchian indicator receives support from stop-losses pushing the price in the direction of "breakthrough".

Turtles Mystery

The most successful and massive application of the indicator was described in the book "Way of the Turtle". Professional market maker Richard Dennis has trained people randomly selected from the street on this strategy. Some of them "propered", but eventually they abandoned this strategy, like their teacher.

The Donchian indicator is a trend system that collapses during the flat period, when the asset quotes move in the same range for a long time. The picture below clearly shows how a series of consecutive losses falls on the trader in this state of the market.

Curtis Faith concealed the fact of changing the strategy, only mentioning it briefly, writing off the failures of other students to their poor skill and not telling the story of the teacher – Richard Dennis - going broke. To survive in the market and reduce losses from the flat, which arise inevitably in any strategy, "Turtles" had to "combine incompatible " - trend and counter-trend trading.

Counter-trend strategy based on the Donchian indicator

For the price of an asset to change direction, disbalance of supply and demand is necessary: at some point, there are more buyers or sellers in the market, so quotes move to new levels.

In case of low demand, the price for a long time can not overcome the offer to buy and sell from large players – funds or banks. In the Donchian channel, such a weakness of the market is determined by the specific form of candlesticks, the lows and highs of which "redraw" horizontal levels, but the closing price remains below the previous stage.

In the picture below you can see how after the new highs of the marked candles there is a reversal of quotations, if their price is below the previous step of the channel.

Rules for opening purchase positions:

1. The horizontal line is redrawn above the maximum of the new, just closed candle.
2. The closing price is located below the channel's previous upper limit.

Rules for opening sale positions

1. The horizontal line is redrawn at the minimum of the current candle
2. The closing price is above the channel's previous lower limit

The position is held close to the middle line of the channel.

The benefits of trading via price channels

Indicators of price channels, as well as elements of graphical analysis, including their construction "by hand" are widely used in modern daily trading. As shown above, the upper and lower limits are ready entry points, as well as a good indicator of the strength of the trend, the reversal of directional movement or degeneration into a flat.

The principles outlined by Donchian in 1970 became the basis for the creation of a whole class of indicators with dynamic channel limits, which became a visual measure of market volatility, predicting future decline or growth of market activity.

Modern programming capabilities make it much easier to receive signals of the Donchian indicator with the help of color signals and alerts sent to the terminal or to the smartphone via Push-messages.