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The use of Donchian channel to identify
Forex currency pair trends and potential breakouts

Visual plotting of highest high and lowest low in currency trading

The Donchian channel indicator was created by the trader and analyst Richard Donchian, one of the respected pioneers of technical analysis, particularly in relation to commodities trading. The indicator is generally freely available, on all the most respected platforms that come complete with a library of easy to apply indicators.

Rather than manually (and at times clumsily attempt to draw our own channel on a chart), the Donchian can automatically and precisely plot it for us. For any traders familiar with the appearance, mechanics and use of the Bollinger Bands, the application of the Donchian will represent a familiar concept and shouldn't present a challenge to use.

Currency pairs on board display

Applying Donchian channel can help forex traders measure the highest high
and the lowest low of currencies, to identify currency pair trends.

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:

  • Identify the tops of markets, or the bottoms
  • It can also be subjected to significant losses from sharp price moves, or from whipsaw trades if a stagnant, range-bound market is present.

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.

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