Day Trading With Donchian Channels
Trading Donchian Channel Strategies
Several trading strategies have been developed based on Donchian Channels, yet day traders may also come up with their own strategies as the indicator is versatile and can be interpreted in different ways.
The Donchian Channel, created by Richard Donchian, plots a line at the high and low price of an asset over a set period of time, typically 20 price bars, such as candlesticks. Upon applying the indicator to a chart, the lines form a channel around the current price.
There is also the option to add a third line between the upper and lower lines. This mid-band is an average of the upper and lower channel lines.
Calculating Donchian Channels
The upper and lower bands are plotted at the highest and lowest price points 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.
For example, assume a trader is using a one-minute chart, and the highest price for stock in the last 20 minutes was $125.50. The lowest price in the last 20 minutes was $125. The indicator will draw an upper line at $125.50 and a lower line at $125. If a mid-band is added, it is drawn at $125.25.
Day Trading Strategies for Donchian Channels
Incorporate Donchian Channels into your trading by using strategies devised by others, such as those discussed below. You can also design your own strategies by testing out the indicator in a demo account first.
The channels are often used as a way to enter potentially emerging trends. You can use the indicator as follows:
- Buy when the price moves above the upper channel line. Short sell when the price falls below the lower channel line. These entry techniques attempt to capitalize on emerging uptrends and downtrends, respectively. Consider exiting if the price reaches the mid-band or the opposite side of the Donchian Channel after entry.
Here are variations of the basic strategy described above:
- 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 aid in highlighting the trend. Only take long trades 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 pull back to the lower band. This is also a potential area to buy since the overall trend is up. During a steady downtrend, the price may pull back to the upper band. As long as the trend is down, short trades can be taken near the upper band. The mid-band can also be used for such trade signals.
- Use a longer-period Donchian Channel for entries, such as the 20-period, then use a smaller period, such as a 15, for exits. Having two sets of Donchian Channels on the screen may make it appear cluttered, so apply different colors to the different channels to distinguish them from 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 channel, and exit when the price rises above the upper band of the shorter period channel.
Play around with the indicator settings to find parameters that align with the market you are trading. The channels may help in isolating when potential trends are starting or ending. No indicator works well all the time. Sometimes the market moves sideways, and those days the trending signals produced by the indicator won't be profitable.
Successful trading always comes down to testing out strategies before using them with real capital. Establish a strategy, test it out over many trades and days in a demo account, then only start using real capital if the strategy produces consistent profits during that time.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.