- : August 8, 2020
- : Prashant Shah
Donchian channels were invented by Richard Donchian. He is known as a father of trend following trading. He was founder of world’s first managed fund in 1949.
Donchian was born in 1905, he got interested in trading after learning about story of Jesse Livermore. Donchian started relatively at young age but was not successful initially in the market. He lost significant money in 1929 crash. But he managed to come back and started practicing again. He was a self-taught chartist and technician. He created strategies using charts and indicators and also studied company’s underlying fundamental characteristics.
He also wrote technical newsletters for over two decades for well-known firms. Donchian was popular and doing good but he was not managing significant size even after being 42 years in the business. He saw great success in his trading and fund management business during his mid- 60’s and continued to achieve new heights. He was trading in his 80’s too.
He is considered to be the creator of the managed futures industry. Publicly held Fund with an idea of diversification was new in 1949. He developed a system-based approach for trading and many concepts which we are being used even today.
Donchian focussed on developing rule-based and systematic approach to trading the markets that would soon become his trend following approach. He taught many students who went on to become successful traders and money managers. In fact, many traders, or analysts whom we study even today were influenced by his work and studied it further.
Donchian used 4-week breakout trading system. Richard Dennis too is said to be inspired by Donchian’s work. His 20-day breakout rule for Turtle trading system is 4-week breakout rule. Of course, there are many other rules in Turtle system which we discussed in the earlier blog. Donchian also worked on moving average crossover systems. He mostly used weekly timeframe.
You will see three lines on the chart when you will plot Donchian indicator on the chart. Upper band, middle band, and lower band. Default parameter is 20.
- Highest high of last 20 bars is upper band.
- Lowest low of last 20 bars is lower band.
- Average of both is middle band. (Upper band + lower band) / 2
So, if today’s high is new 20-day high, you will see upper band rising.
Simple? You know the indicator well now, right?
So think before reading further...
what does it mean when you see lower band rising?
That means the lowest low was first bar in last 20 and that bar is dropped from the calculation now. In simple words, range is changed. There is a new 20-day low which is higher than the previous low. So, easy to understand what it means when we see upper band falling.
So, on a given bar - there are below mentioned possibilities for both the bands:
So this way, state of the market can be decided based on the positioning of Donchian bands. How if we define and score the shape of bands:
Rising upper band = Bullish (2)
Falling lower band = Bearish (-2)
Falling upper band = Semi-Bearish (1)
Rising lower band = Semi-Bullish (-1)
Flat upper band = Neutral (0)
Flat lower band = Neutral (0)
Let us score above setups now:
Now see the same diagram:
When a greater number of stocks in the group are in score 0 – it is a range bound market. When a greater number of stocks have a bullish score – it is a bullish market, trust breakouts. This can be calculated on multiple periods to gauge the strength of trend on multiple timeframes.
If today’s low is new 20-day low, you will see lower band is falling.
Let us discuss the indicator further.
Remember, after going below lower band if price goes abvoe upper band - it is a fresh bullish breakout. Otherwise, it is continuation bullish breakout. Vice versa for bearish breakout.
What is middle band?
If I combine all 20 candles and make one: High of that candle is highest high of 20-bars (upper band) and low is lowest low of 20-bars (lower band). Average price of this candle (High + low) /2) is a middle band. When middle band rises, that means average price of last 20-days is rising and vice versa.
Middle band is logical indicator as well. Roughly, 20-day momentum indicators would be above mid-value when price is above Donchian middle band and vice versa.
To keep it simple,
Distance between upper and lower Donchian bands tell us about volatility as well. When distance is higher, market is volatile. When distance is not much – market is in narrow range. We can calculate Donchian bandwith indicator – more about that later.
So, you can plot Donchian band whenever you need high or low of last certain period in your system. There are many types of rules possible using Donchian bands.
- Price > Middle band = Bullish zone
- Price < Middle band = Bearish zone
SAR: Trade upper band and lower band breakouts – it becomes SAR (Stop and reverse) method in that case.
Trend following (Non-SAR): Middle band can be used as a stop-loss for upper band and lower band breakouts.
Price patterns: You can also combine it with price patterns. Look for bullish price patterns in bullish zone, and bearish price patterns in bearish zone.
Pullback: Bullish pattern near middle band during retracement after crossing upper band is a bullish pullback setup.
There will be whipsaws when trend is not strong. Follow through, price patterns or confirmation from different tools can help us reducing whipsaws. But try to make it as objective as possible. Remember, Donchian teaches us to be a systematic trader.
You can combine it with other indicators as well – but I want to talk more on how to user combination of indicators. It is a remarkably interesting subject.
20-day is a default parameter and used in this writeup. Do experiment around it. Plot Donchian channel on Noiseless charts – it’s a very useful concept they show range breakout minus time bars.
There are some trading guidelines by Donchian. Some important points from his trading guidelines were said to have been published in one of his newsletters:
This subject gave me opportunity to talk about Richard Donchian’s inspirational journey. Lost heavily initially, fought back, learned from mistakes, developed own approach that is helping generations. Contributed through reports, writeups, found first managed futures fund, developed systematic trading, trend-following approach, taught many who became successful in the field. Found meaningful success after working for around 42 years in the field and in his 60's. His contribution to Technical analysis will always be remembered and continue to inspire the future generations.
- If everyone is talking about it, do not act immediately. Even if it is right – move gets delayed.
- Dullness is followed by a trend. Keep a note of direction in which volume increases during that period – that is the likely direction of breakout.
- Whatever else you do, limit the losses, and ride the profits. Every experienced trader would say this, but it is not easy to implement.
- Go light when market direction is not certain. Wait for clearly defined moves and concentrate on them. It will help you to prevent unprofitable trades.
- Stops are a valuable tool for profitable trading. It can be used to limit the loss, protect the profits, and save from patterns that did not work. They are amazingly effective fwhen applied based on chart patterns.
- When entering the trade – price limits are fine. When exiting the trade – use market orders.
- Buy Strong and sell weak. Trade strong trending markets.
- Previous peaks or bottoms, or a price area where stock traded in narrow range in past are strong support – resistance areas.