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Donchian Channel Strategy

Author: Consultant Finmaxfx

Every forex trader faces a dilemma at some stage of the decision-making process in trading: is it worth holding a profitable position in strong-trend market conditions, or is it becoming riskier due to the overbought/oversold ranges reached by the price? Sometimes it happens that a strong trend has been missed somehow and perfect entry levels are rather far from the current price action. Traditional oscillators show an extreme territory, pointing to a potential reversal while the trend momentum isn’t exhausted yet. The same question is traditionally asked when a trader already has a profitable position running and his goal is to find the best moment to add some trading volume, increasing the total profit. Another example is related to certain price ranges, which could lead to an acceleration of the current trend once breached. Normally, traders avoid entering the market on breakthroughs as the likelihood of whipsaws and sudden reversals weighs on the overall success at the end of the day. That’s one of the main targets for any analysis - maximizing profits and minimizing losses. Donchian Channel breakout is used exactly in these occasions when it’s needed to assess the probability of further movement in the same direction, balancing the risk associated with a late entry.

In contrast to traditional forex trading techniques, based on technical indicators measuring oversold and overbought levels, donchian trend system points to certain ranges where the breakthrough might lead to further development in the trend. It’s often seen when buyers, for example, eliminate sellers’ defensive barriers with heavy-volume demand for an asset. Such a process happens so quickly that the trading software is unable to find closest prices near the current range and quotes tick sharply as the supply is shifted far to the next resistant postponed orders.

That scenario is called a breakthrough and it might cause lucrative profits if measured correctly.

What is a Donchian Channel?

Donchian Channel is a follow trend technical, similar to the Bollinger Bands approach, measuring trends momentum for a given period of time. The key mathematical idea is to calculate the highest (upper range) and lowest (bottom line) prices for n period, while the middle line represents an moving average price. Richard Donchian developed this technical tool in the middle of the twentieth century. Every bullish attempt of the price to near the upper line will push the bottom band of the range up and vice versa. In contrast to the Bollinger Bands, Donchian Channel does not take in the count market’s volatility though. Two different settings are used for Donchian Channel Indicator in this strategy: periods 20 (blue background) and 55 (yellow background).

A long position should be opened when the price crossed upwards the top blue line of Donchian Channel 20 period (blue font). A second breakout of the blue top line has to be ignored for the Donchian Channel indicator with 20 period. However, if the price breached through the top green line of Donchian Channel indicator with 55 period (yellow background), then one more long position entry has to be considered.

How to use Donchian Channel Indicator?

Exiting the market would be more effective using a trailing stop order, the depth of which depends on the timeframe chosen and the asset. For example, EUR/USD on the H1 timeframe would suggest 35-pips trailing stop, while the stop-loss order should be placed 2-3 pips below the bottom green line of the Donchian Channel indicator with 55 period. A fixed stop-loss range is usually effective in 40 pips to range in this case. Another option to exit the market is on take-profit order when the price reaches a certain level in the right direction. For EUR/USD on the 60-minutes timeframe, it’s normally equal to 30 pips, GBP/USD: 35 pips, AUD/USD: 30 pips, USD/CHF: 25 pips. A ratio of 1:3 with the initial stop-loss order is also applicable. Every 20 pips of additional gain should move the stop-loss order at the entry level or above, shifting the lower band of the profitable range. So, it would be better to monitor current opened positions while trading but leaving them for the orders’ automatic control.

If you like this strategy, you might also be interested in this Parabolic SAR Strategy

Short positions are opened in a mirror opposite conditions when the price breaks the bottom blue line of the Donchian Channel 20(blue background) while adding more volume is only possible when the price crosses the top green line of 55-bars Donchian Channel (yellow background).

Exit conditions are same as described above for the long positions.

The example of Donchian Channel breakout is illustrated below for EUR/USD on the H1 timeframe:

Donchian channel indicator

Donchian Channel formula

UC = Highest High in Last N Periods Middle Channel=((UC−LC)/2) LC = Lowest Low in Last N periods where: UC = Upper channel N = Number of minutes, hours, days, weeks, months ​ Period = Minutes, hours, days, weeks, months LC = Lower channel

See also: