The Donchian Channel helps identify volatility but its primary use is to trigger long or short trades. Also used to automatically locate support and resistance.
Indicator Type
Trend following indicator
Works Best
All market types and time frames. Since this is a trend following system it would be beneficial to also use a trend filter such as a moving average crossover or directional index to identify to the trend.
Formula
The channel is formed by taking the highest high and the lowest low of the prior n periods.
The median line is the average of the upper and lower band for each period and not a moving average of price.
Parameters
The indicator was created to track one month of data so a 20-period parameter was the original. defaults to this period in all time frames for both the high and the low. Change either or both by entering it in the box.
Check the “channel fill” box to shade the area between the bands. Shading color is based on the median line color.
You can also select color for the each line by selecting the boxes next to each to bring up a color palette.
Theory
The Donchian channel is a useful indicator for quantifying volatility. If price is stable the channel will be relatively narrow. If price is volatile will be wider.
Its primary use, however, is for providing signals for long and short positions. If a security trades above its highest n periods high, then a long is opened. If it trades below its lowest n periods low, then a short is opened.
Theoretically, new highs lead to even higher prices as trends progress. That is why it is important to confirm that a trend is actually in place. During trading ranges, new highs are overbought signals.
Interpretation
The channel is based on the concept that a new high should be bought and a new low should be sold. In addition, after a channel break, the new high then becomes support and the new low becomes resistance.
Traders buy a new high and hold until one of three events occurs: 1) the upper band is negated, 2) price moved through the lower band, price moves through the median line or 4) a traditional stop is hit. This is based on preference and aggressiveness of the trader but choice 2) is most common.
When price closes above the channel, buy long and cover short positions. When price closes below the channel, sell short and liquidate long positions. Use a trailing stop for exits or wait for a cross of the opposite channel line.
