Day Trading With Donchian Channels

Understanding and trading Donchian Channel strategies

day trading with donchian channels
Basic 20-period Donchian Channel applied to 1-minute stock chart. FreeStockCharts.com

The Donchian Channel, created by Richard Donchian, plots a line at the high and low price over a set period of time, typically 20 price bars. Day traders apply the indicator to their charts. The channels overlay the price action, showing the highest and lowest prices (as continuous lines) over the specified number of price bars, regardless of whether viewing a tick, 1-minute, 5-minute, or any other chart time frame.

Donchian channels are useful for highlighting trends as well a ranging periods. Several strategies have been developed based on Donchian channels, but day traders can also come up with their own, as the indicator is quite simple and can used in many ways.

It is called a "channel" because there are two lines to the indicator--one which runs along the highs of price bars, and another that runs along the lows. There is also the option to add a third line between the upper and lower lines. This third line is an average of the upper and lower channel lines (bands).

Donchian channels can be applied to any market, such as forex, stocks, options or futures charts. 

How to Calculate Donchian Channels

The upper and lower bands are plotted at the highest and lowest price over a specified number of periods, such as 20 price bars. 

The indicator does not include the current price bar in the calculation. In other words, if you choose to apply the indicator over 20 price bars, the bands are calculated and plotted based on the 20 prior price bars.

The attached chart shows an example of Donchian Channels applied to a 1-minute stock chart.

Day Strategies for Donchian Channels

There are many ways to use Donchian channels, and you can develop your own Donchian Channel strategies, or incorporate the indicator into your current strategies if it improves the performance of your trades.

 

The channels are primarily used as a way to enter potentially emerging trends.

  • Buy when the price moves above the upper channel line, and then exit when the price falls below the lower channel line. Short sell when the price falls below the lower channel line, and exit when the price moves above the upper channel line. The former attempts to capitalize on an emerging up move in price, and gets you out when the price may be starting to reverse back to the downside. The short sell strategy gets you in as the price may be starting a move lower, and gets you out if the price starts to rally again. 

The strategy above is the most basic, but variations are recommended to make the strategy more effective. 

  • Not all moves above the upper band, or drops below the lower band, warrant a trade. Add a trade filter, such as a moving average, to further aid in highlighting the trend. Only take long trades (buy) if the price is above the moving average, and only take short trades if the price is below the moving average. 
  • During a steady uptrend, the price may tend to pull back toward the lower band. This is also a potential area to buy, since the overall trend is up. During a steady downtrend, the price may tend to pull back toward the upper band. This is also a potential short sell area, since the overall trend is down. 
  • Use a longer period Donchian Channel for entries--such as the 20-period--but then use a smaller period--such as a 15--for exits. Having two sets of Donchian Channels on the screen can make the chart a bit cluttered, so apply different colors to the different channels to distinguish them for each other. Buy when the price rises above the upper band of the longer period (20) channel, and exit when the price falls below the lower band of the shorter period (15) channel. Short sell when the price falls above the lower band of the longer period (20) channel, and exit when the price rises above the upper band of the shorter period (15) channel.

Final Word on Day Trading with Donchian Channels

Play around with the indicator settings to find parameters that align with the market you are trading. The channels should help you isolate when potential trends are starting or ending.

No indicator will work all the time. Sometimes the market tends to move sideways, and on days like that trends won't develop and so the indicator will likely produce trade signals that result in a loss. Adding another indicator to help filter out some of the trades can aid in this regard, as can using a shorter period Donchian channel to signal an exit. 

Successful trading always comes down to testing out strategies before you use them with real capital. Establish your strategy, test it out over many trades and days, and only if it works for you should you proceed to using it with real capital.