How to Use the Donchian Channel

Donchian channels establish the bounds within which a security has traded over a given period.

When trading securities, some investors use an indicator called the Donchian channel to measure price movements and volatility of a particular stock, currency, commodities future or other instrument. Traders also use the Donchian channel to find attractive entry and exit points for trades according to its upper and lower limits, also known as Donchian bands. Generally, investors see a breakthrough above a Donchian channel as a signal to buy because the security may trade higher. A breakthrough below a Donchian channel is often seen as a sell signal, indicating the security may trade lower.

Things You'll Need

• Chart of security being analyzed
• Trading software (optional)

Instructions

1. Determine the highest high price of the preceding "N" number of trading periods, not including the current session, to establish an N-day upper Donchian band. For example, the highest price of a share of a given stock over the previous 20 sessions establishes the upper 20-day Donchian band. Many investors see price breakthroughs above the upper Donchian band as a buy signal.

2. Find the lowest low price for the previous "N" number of trading periods, not including the current session, to establish an N-day lower Donchian band. For example, the lowest price of a share of a given stock over the previous 20 sessions establishes the lower 20-day Donchian band. Many investors see price breakthroughs below the lower Donchian band as a sell signal.

3. Revise the upper or lower Donchian bands whenever the highest or lowest closing price over the past N sessions changes. An upper Donchian band will rise if the highest closing price over the past N periods rises, and a lower Donchian band will rise if the lowest closing price over the past N periods rises. As such, a Donchian channel closely follows the ranges within which a security trades over a given period, and its upper and lower limits form borders within which a security generally trades.

4. Buy securities when they trade above an upper Donchian band and sell them when they trade below a lower Donchian band. Successful traders tend to incorporate this indicator along with other pieces of analysis to provide more conviction in their approaches.

Tips & Warnings

• Trading software often includes calculations of Donchian channels to help investors spot attractive entry and exit points.

• The Donchian channel offers a way to follow trends in trading, but it is only one method for evaluating attractive entry and exit points. Trades based solely on analysis of Donchian channels is very risky, so additional analysis may be warranted.

• Any trade above or below a Donchian band can be interpreted as either a buy or sell signal, depending on variables taken into account. There are no hard-and-fast rules that govern trading, and price movement in one direction or another can quickly be followed by unexpected reversals.

• Trading securities is a high-risk financial undertaking, and should only be undertaken on thorough research and after precautions are taken to mitigate losses. Consult with a financial adviser before attempting trades.

References

• IndicatorForex: Using the Donchian Bands
• Investopedia: Capture Profits Using Bands and Channels
• "Trend Trading: Timing Market Tides"; Kedrick F. Brown; 2006
• Financial Newsline: Donchian Strategy for Trend Trading