Richard Donchian created a system he called the Donchian 5 20 system in 1961. The system involves the use of the 5 day moving average and the 20 day moving average. Donchian believed that the 5 and 20 day moving averages have a special relationship because there are about 4, 5 day periods in a month or about 20 trading days excluding weekends.
Donchian’s idea was to use a break of the 20 day moving average as a buy, and a retracement exceeding the 5 day moving average as a sell. The price must not only cross above the 20-day moving average but also exceed any previous 1-day break by at least one volatility measure.
The Donchian 5 20 System was designed for commodity futures trading but in this lesson, I will adapt those rules to regular stock trading. This is a variation of the 5 20 system created for stocks and is therefore different from the original 5 20 system which was created for commodity futures trading.
When the 20 day moving average is broke, a buy signal is not given until one day confirms the break. The confirmation day must close above the high of the broken 20 day moving average day. No break above the 20 day moving average should be used as a buy signal unless it has at least one day confirmation where the price closes above the signal day.
If the confirmation day does not confirm and is instead a retracement day, the price will fall back below the 20 day moving average. This is ok and does not negate the 20 day moving average break buy signal. Continue to keep track of the original confirmation level (which is a close above the 20 day moving average break day). The next time the 20 day moving average is broke, it is a buy only if the 20 day moving average break exceeds the previous 20 day moving average break.
The signal only stays valid for at most 25 trading days. Act on all closes that cross the 20-day moving average, confirm with a one day close above (or below, in the direction of the crossing) for up to 25 daily closes after the original signal.
Within the first 20 days after the first day of a crossing that leads to an action signal, reverse on any close that crosses the 20-day moving average and confirms with a one day close (above or below) the previous 15 daily closes.
A stop loss using the 5 day moving average rules for closing out positions and for reinstating positions in the direction of the basic 20-day moving average trend are:
Close out positions when the price closes below the five-day moving average for long positions or above the five-day moving average for short positions with at least a one day confirmation close more than the greater of a) the previous penetration on the same side of the five-day moving average, or b) the maximum point of any previous penetration within the preceding 25 trading sessions.
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