Richard Donchian was a futures trader, that’s credited with creating the popular Donchian Channel Indicator. Richard Donchian is recognized as the father of trend following.
The Donchian Channel is formed by taking the highest high of x length of time, and the lowest low of the same x number of days, then marking the region between those values on a stock chart.
The Donchian channel is a helpful indicator for watching the volatility of a market price. When a price is stable the Donchian channel will be reasonably slim. In case the price fluctuates a lot the Donchian channel is going to be fatter. Its main use, having said that, is designed for providing signals for long and short positions. If a stock trades above its highest x day high, then a long trade is made. When it trades below its lowest x day low, then a short position is entered into. They’re very helpful for predicting support and resistance levels of price and define boundaries for price action.
How It’s Used
The Donchian system uses bands which are mostly used as a breakout indicator – they define support and resistance and creates entries as price breaks these levels. Because lows and highs normally correlate with support and resistance levels, this indicator is helpful in objectively defining these levels.
On the other hand, it may also be used as a reversal signal – entering when price touches a band and reverses its direction. Before utilizing the indicator in this way, confirm the credibility of the psychological level by demanding at the least 2 touches at the level. This helps to ensure that the signal is good and improves its reliability.
One other way of trading the Donchian Band is using its middle band. The middle band is the average of the upper and lower band, and can also be employed to quantify trend. Entry signals are made in the following way: When price crosses the middle band from below – buy, and when price crosses from above – sell. It’s rather a effective signal when trend strength is confirmed (with support and resistance or other indicators).
Buying And Selling Using Donchian Bands
There are various Donchian system strategies to interpreting and trading the Donchian Bands. By far the most frequently employed is definitely the breakout:
1. Long Trades – Long trades are entered when price breaks above the 20-period upper Donchian Band. Risk adverse traders wait for price to close above the Donchian upper band to get into the position.
2. Short Trades – Short trades are entered when price breaks below the 20-period lower Donchian Band. Risk adverse traders wait for price to close below the Donchian lower band to enter the trade.
Another technique of using Donchian Bands is using the middle band as the buy or sell signal line. Entry signals are created in the following way: When price crosses the middle band from below – buy, and when price crosses from above – sell.
Donchian System and Twenty Stock Trading Rules
Richard Donchian started out his Wall Street livelihood in 1930. Donchian started out writing a technical market letter in 1933, and continued for many years. In 1934, Donchian came up with the below twenty trading tips that are based in human psychology. Human psychology never changes thus these rules remain suitable today.
1. Be careful of acting right away on a common public opinion. Even if correct, it will usually delay the move.
2. From a duration of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume increases.
3. Limit losses and ride profits, irrespective of any other rules.
4. Small positions are highly recommended when market position is not certain. Clearly defined moves are signaled frequently enough to make life interesting and concentration on these moves may prevent unprofitable whip-sawing.
5. Rarely take a position in the direction of an immediately preceding three-day move. Wait for a one-day reversal.
6. Prudent use of stop orders is a valuable aid to profitable trading. Stops are useful to protect profits, to limit losses, and from certain formations such as triangular foci to take positions. Stop orders are inclined to be more valuable and less treacherous if used in proper relation to the chart formation.
7. In a market in which upswings will probably equal or exceed down swings, heavier position should be taken for the upswings for percentage reasons – a decline from 50 to 25 will net only 50% profit, whereas an advance from 25 to 50 will net 100%
8. In picking a position, price orders are allowable. In closing a position, use market orders.
9. Buy strong-acting, strong-background commodities and sell weak ones, subject to all other rules.
10. Moves in which rails lead or participate strongly are usually more worth following than moves in which rails lag.
11. An analysis of the capitalization of a company, the degree of activity of an issue, and whether an issue is a sluggish truck horse or a spirited race horse is fully as important as a study of statistical reports.
12. A move followed by a sideways range often precedes another move of just about equal extent in the same direction as the original move. In general, when the second move from the sideways range has run its course, a counter move nearing the sideways range can be anticipated.
13. Reversal or resistance to a move is likely to be encountered:
A. On reaching levels at which previously, the commodity has fluctuated for a considerable length of time within a narrow range
B. On nearing highs or lows
14. Watch for great buying or selling opportunities when trend lines are approached, especially on medium or dull volume. Be sure such a line has not been hugged or hit too frequently.
15. Watch for crawling along or repeated bumping of minor or major trend lines and prepare to see such trend lines broken.
16. Breaking of minor trend lines counter to the major trend gives essential position taking signals. Positions can be taken or reversed at such places.
17. Triangles of ether slope may mean either accumulation or distribution depending on other factors although triangles are usually broken on the flat side.
18. Beware of volume climax, particularly after a long move.
19. Never rely on gaps being closed until you can separate breakaway gaps, normal gaps and exhaustion gaps.
20. During a move, take or increase positions in the direction of the move at the market the morning following any one-day reversal, however slight the reversal may be, in particular when volume declines on the reversal.
Donchian channels are more effective when used with Fibonacci retracements. Please review this lesson on trading Fibonacci retracements.
Below is a video lesson I created for YouTube on the Donchian system that went viral with more than 60K views. Enjoy.
