From assessing volume to signaling, Donchian Channels could be the ideal tool for helping traders to benefit from defined boundaries in a volatile market.
The Donchian channels indicator assesses market volatility by taking the biggest high and smallest low of a past period defined by the user (which is normally set to 50). The span of these two points contains channel activity over this duration.
Donchian channels are superimposed over the price chart so that traders can see where the price is sitting at the moment in comparison to the channel’s top and bottom boundaries. You can add a line in the middle to show the midway point in between the channels.
The market has recently experienced various highs and lows in this 50-day timeframe. The Donchian channels show a range between these points to highlight them.
It’s a given that during a shorter period channels will look more squashed. You’ll get broader ranges if you use a bigger dataset.
What to Use the Donchian Channels For
When prices aren’t fluctuating, then Donchian channels will naturally be quite tight, but when prices are more volatile they will tend to open up.
It’s down to the individual trader and their overall strategy as to how they use this information, but since the majority of them will be using directional strategies, some of their profits will hinge on gaming price volatility to their benefit.
Some like to seek opportunities when the market is more quiet, using particular technical analysis strategies that can be advantageous during times when there aren’t so many pronounced price shifsts. There approaches might include using calendar spreads or buying an in-the-money call option and in-the-money put option in a way that maximizes profit if the asset stays within a specific region.
You’re free to use Donchian channels alone for trading directionaly. For instance, if a price breaks north of its X period high, then you can see that as the start point of a long trade. But if it breaks below its X period low, it could suggest that a short trade would be the best tactic.
If price skims the midpoint line this could be viewed as an exit signal, and you can add this by moving the settings, or by getting the signal from another tool.
If you want to look at the Donchian channels in this way, then it automatically makes them a tool suited to following trends.
Example
Looking at a daily chart of the S&P 500 once more, it’s clear that by using a 50-day period for the Donchian channels with the rules we mentioned (go long if you see a close above the channel, and close if it brushes the midline), there are a pair of opportunities in the last nine months. The first one did quite well, and the other did very well.
At the other end, you can use Donchian channels on shorter timeframes like hourly, 15-minute, 5-minute chart or anything inbetween.
As you shorten the timeframe and lower the period of the channels, you’ll get more frequent signals (so long as trade signals are being based on the price closing above and below the channels.) But it’s worth remembering that you won’t automatically get profit just because you use more frequent signals.
To conclude
Donchian channels show market volume by highlighting the gap that separates the high and low points within the most recent number of periods that the user wants to look at.
While they are good for assessing volume, some traders may want to use them for actual signaling, in a trend-following context.
Enter into long trades when there’s a break north of the top band and go with short trades when there is a break under the level band. Exit from trades when you are signaled to by another indicator, when the midpoint line is brushed and you can add that in.
