Plotting the Donchian channel on the chart
The Donchian channel (DC) plots two lines on a chart; the highest high, identified over a set period and the lowest low, identified over the same period, the area in between therefore becomes the channel. A channel is easily calculated and drawn automatically by the charting package on, for example, the MetaTrader 4 platform where the indicator is available to download, but as a custom indicator only.
The period most commonly used for the channel is a 20 day period. The rationale behind the calculation of this standard period, is straightforward; five trading days in a week, four trading weeks in each month. This time period also becomes highly relevant for the monthly contracts many securities are trade as.
The Donchian channel (DC) can prove to be an extremely useful indicator for:
Observing the volatility of price on any given security
If price is relatively stable and potentially in a trend, then the Donchian channel will be displayed in a fairly narrow field. If price fluctuates considerably, then the Donchian channel will take on a wider appearance.
For identifying signals for long or short positions
Theoretically; if a security trades above its highest n periods high, then a long trade is potentially identified. If a security trades below its lowest periods low, then a short is potentially identified.
Combining Donchian channel with other indicators
However, the simplicity of the DC should not lead traders to rely on it singularly; a breakout could indicate the start of a long-term trend, or it could be triggering a possible reversal. The DC doesn't provide new information, it simply allows traders to visualize information easily obtained through other methods. Therefore, many traders will also use complimentary indicators, such as the RSI (Relative Strength Index), illustrating potential oversold and overbought conditions, in order to cross check their trading entry and exit decisions.
As a complimentary addition to an indicator based trading strategy, the DC is often used visually; to establish if price is staying close to the upper band, or remaining close to the lower band. As such traders can (in theory) identify stronger bullish, or bearish trends. It's always worth looking for patterns, where the top or bottom line of the channel, 'sticks' close to the current price.
Few limitations of the DC indicator
Similar to the majority of trending indicators, a DC trading method cannot:
Entry and exitmetrics can be adjusted to counter these situations. In doing so traders must be mindful that they're potentially corrupting the original mathematical purpose and curve fitting the indicator to suit current market conditions.
As a standout visual, for automatically drawing channels and identifying potential trends and trend lines, the DC offers up an excellent alternative to the (at times) imprecise manual drawing/creation of channels and trend lines. For novice traders it offers up a tremendous opportunity to become familiar with simple, technical, indicator based trading strategies and despite its simplicity it's still one of the main 'go to' indicators preferred by experienced traders.
Updated on 28. October 2017
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