El Donchian channel is a technical indicator trend type represented as a dynamic market price channel based on price movements.
The Donchian channel is a technical indicator, as it is part of the technical analysis. In addition, it is a trend indicator because it aims to identify which is the main market trend. And, its graphic representation is as a dynamic channel. What does dynamic mean? That is a channel that changes as the price moves. Its appearance is as follows:
As we can see in the price chart, its appearance is very simple. A Donchian Channel has three main lines. One superior, one intermediate and one inferior. For those more deeply into the subject, it could be said, and justifiably, that it bears some resemblance to the Bollinger Bands.
It was in the 70s when Richard Donchian, an expert in technical analysis and in the futures market, created the channel that bears his last name. According to experts, this indicator was the origin of trend following trading systems. Also called, trend trading systems.
Donchian Channels Formula
Next we will explain how each of the three lines of the Donchian channel is calculated. Like any technical indicator, this indicator has a formula that, when calculated, represents its expression in the price chart. Being formed by three lines, its formula is composed of three conditions. Donchian’s channel is calculated as follows:
- HH or Top line = Maximum price of the last «n» periods
- LL or Lower line = Minimum price of the last “n” periods
- Intermediate line = (Top line + bottom line) / 2
HH means the highest of its maximums by its acronym in English (Highest High). LL the lowest of the minimum (Lower Low).
The value of “n” will depend on the analyst. For example, a 10-period Donchian channel, where the periods are days, will be calculated as follows:
- HH or Top line = Maximum price of the last 10 days
- LL or Bottom line = Minimum price of the last 10 days
- Intermediate line = (Top line + bottom line) / 2
Like any technical indicator, it can be used in any period. That is, from minutes and hours, to months and years. However, it is recommended to use the 20-day Donchian channel.
How to trade with the Donchian Channels?
As we said at the beginning, this indicator assumes, according to experts in technical analysis, the principle of trend following trading systems. Whereupon, Richard Donchian created this indicator as a trading system. Richard Donchian established rules to trade based on this indicator. The rules for opening and closing positions were very simple.
- Long position opening: A long position is opened when the price exceeds the maximum of 20 days. That is, when the price exceeds the top line.
- Long position closing: The long position closes when the price loses the minimum of 20 days. Or what is the same, when the price crosses the bottom line down.
- Short position opening: A short position is opened when the price exceeds the minimum of 20 days down. In other words, when the price crosses the bottom line down.
- Short position closing: The short position closes when the price exceeds the maximum of 20 days. In other words, when the price crosses the upper line upwards.
If we pay attention to the trading rules, we can realize a very peculiar detail. When a long position is closed, a short position is automatically opened. And vice versa, when a short position is closed, a long position automatically opens. From this we can deduce that this trading system is always in the market. That is, it always has some open position.
As a conclusion we can say that it is an extraordinarily useful indicator to obtain benefits in markets that are in trend, regardless of whether the trend in question is bullish or bearish. We must remember that the trending markets are the ones that can generate more profits for the trader if we are able to capture a good trend. However, in markets with high volatility or sideway markets we can incur in considerable losses.
