When it comes to trading in the stock market, it helps to make use of patterns and indicators. They can help you take accurate trading decisions and limit your losses at the same time. Among the various technical indicators that are available, very few are as powerful as the Donchian channel indicator. It gives you a lot of information about the market movement and the existing trend, thereby allowing you to place your trades accordingly. If you’re wondering what the Donchian channel is and how to use it, here’s what you should know.
What are Donchian channels?
The Donchian channel is a technical indicator that was developed in the twentieth century by a prolific derivatives trader named Richard Donchian. The indicator makes use of moving averages to identify and determine high, low, and median prices of a stock or an asset over a specific period of time. This information is then collated by the indicator, which can then be used by a trader to base his trading decisions.
Generally, Donchian channels are widely used by traders to determine the support and resistance levels of an asset, to identify breakout and breakdown points, and to identify prevailing or new trends. In a way, the Donchian indicator is quite similar to the Bollinger Bands.
What does the Donchian channel indicator look like?
Now that you’ve been introduced to the concept of the Donchian indicator, let’s dive right into the specifics and see what this indicator looks like.
Here’s a 1-month Nifty 50 chart that clearly indicates the Donchian channels for a 20-day period. The Donchian indicator is highly versatile and can be customized according to the time period of your choice.
As you can see here, the portion highlighted in blue is the Donchian channel indicator. It consists of three different channels, namely, the upper channel, the lower channel, and the median or middle channel. The upper and lower channels are highlighted in blue here, with the middle channel being highlighted in orange.
The upper channel in the Donchian channels indicator denotes the highest price of the asset during the specified time period, which in this case is 20 days. Similarly, the lower channel in the Donchian indicator denotes the lowest price of the asset during the set time period. The median or the middle channel represents the average of both the upper channel and the lower channel.
How to use the Donchian indicator to make trades?
Okay, so let’s delve even deeper into this concept and see how the Donchian channels can be used to identify breakouts and breakdowns.
Scenario 1: Breakout
The best way to identify an oncoming breakout trend is to keep an eye on the upper channel of the Donchian channel indicator. When the price of an asset touches or skirts the upper channel, a breakout is said to be on the cards. As you can see from this picture here, the price of the asset touches the upper channel of the indicator, which then starts a new uptrend.
Therefore, the point marked is what traders call the ‘breakout point’ and should ideally be the point of entry. To be on the safer side, you could always monitor the candles that appear after the breakout point to ensure that the trend has indeed solidified before getting into a long position.
Scenario 2: Breakdown
To accurately identify a forthcoming breakdown trend, all that you need to do is keep an eye on the lower channel of the Donchian channels. Whenever the price of the asset skirts or touches the lower channel of the Donchian indicator, a breakdown is said to be on the table. The above picture confirms this. Take a look at the first two candles in the picture. The first candle almost touches the lower channel, while the second one does in fact touch it. Once the price touches the lower channel, it sets off a new downtrend in the asset’s price.
And so, the point marked is what traders call the ‘Breakdown point’ and should ideally be the point of entry. Always remember to closely monitor the candles that make an appearance after the breakdown point. This way, you can be on the safer side of things by making sure that the trend has solidified before getting into a new short position.
As you can see, the Donchian channel indicator is quite easy to use and interpret and gives you a wealth of information on the price movements of an asset. Since all of the charts and tools are automated these days, all that you need to do is visit your favorite charting tool, select the asset, and choose the time period for which you require the Donchian indicator. The tool would automatically plot the channels for you using the dedicated formulas for the indicator.