Donchian Channels – What Are They and How to Use Them

What are Donchian Channels?

Richard Donchian, a commodities and futures trader created the Donchian Channels as a technical indicator to help traders identify trends better. Richard later came to be renowned as the ‘Father of Trend Following.’

A Donchian Channel consists of three bands – the upper channel, the median channel and the lower channel. The median channel is basically the line connecting the average of the period’s high and low. And the upper and lower channels are the lines drawn at the highest high and lowest low of the period in consideration.

Day traders can create their own variations of this trend indicator as it can be interpreted in several ways and can thus be tweaked to suit different rationales.

How are Donchian Channels calculated?

The Donchian Channel formula is a three-part calculation:

The first step is to choose the period that you wish to evaluate i.e., ‘n’ minutes, hours, days, weeks, months, etc. This is a common step for calculating all three channels. Richard Donchian typically used 20 days.

1. Upper Channel (UC)

Over the span of ‘n’ periods, compare the highs of each minute/hour/day, etc. for that period. Pick the highest high and plot the result on the price chart. Hence the formula for the upper channel is:

UC = Highest high in the n-period timeframe

2. Lower Channel (LC)

Over the same ‘n’ period timeframe, compare all the lows of each minute/hour/day, etc. Pick out the lowest low from those data points and plot a line on the price chart. Thus the formula for the lower channel is:

LC = Lowest low in the n-period timeframe

3. Middle Channel

In the n-period timeframe under consideration, the highs and lows for each minute/hour/day, etc. have to be noted, added, and divided by 2 to arrive at the data points for plotting. The formula of the middle channel is therefore:

Middle Channel = (UC + LC)/2

Trading with Donchian Channels

After looking at the Donchian Channel calculations, it is clear that the upper and lower channels simply indicate the highest and lowest price seen on the price chart in the n-period timeframe. Therefore these channels act as indicators of support and resistance.

You must already be aware that prices of a security rarely remain at a steady level. They keep fluctuating up and down according to investor sentiment which in turn relies on several factors like macroeconomic health, government policies, geopolitical developments, etc. So, when price movement becomes large, the Donchian Channels spread further apart and widen. Similarly, when prices move in a narrow range, the Donchian Channels come closer together and narrow down.

Use of Donchian Channels in trading

There are two ways in which these are used in trading:

1. Breakout Indicator

When the upward or downward momentum in price action causes it to reach the upper or lower Donchian Channel, it gets that much closer to breaking out. When this happens, traders can decide more easily whether they want to enter or exit positions. When a stock trades at a price below a Donchian Channel, traders short their positions, and they can take a long position when the stock price trades higher than the Donchian Channel.

2. Middle Channel Trading

Since the middle channel is the average of the upper and lower Donchian Channels, it is invariably used as an early indicator of a potential breakout. When the price drops below the middle channel, traders enter short positions to escape downside losses. Similarly, when the price moves above the middle channel, traders enter long positions with the hope of making gains.

FAQs

Are Donchian Channels easy to understand for beginners?

Yes, beginners can easily understand as well as learn to trade using this simple indicator.

Are Donchian Channels the same as Bollinger Bands?

No, Bollinger Bands are actually more accurate indicators than Donchian Channels. Bollinger Bands move more in sync with the stock price and help traders better gauge the volatility and overbought/oversold situations.