Day Trading With Donchian Channels

The Donchian Channel, created by Richard Donchian, plots a line at the high and low price of an asset over a set period of time, typically using candlesticks as a timepiece. Candlesticks, so called because of their shape, are plot areas on charts that demonstrate the open, high, low, close price, and time frame of a given stock. Upon applying the indicator to a chart, the lines form a channel around the current price. 

Donchian Channels are useful for highlighting trends as well as ranging periods when day trading. There is also the option to add a third line between the upper and lower lines. This mid-band is an average of the upper and lower channel lines. The indicator works on all time frames, such as one-minute or five-minute charts (in which a bar forms every one or five minutes), and it can be applied to forex, stocks, options, or futures markets. 

Calculating Donchian Channels

The indicator does not include the current price bar in the calculation. In other words, if you choose to apply the indicator over 20 candlesticks, the bands are calculated and plotted based on the 20 prior candlesticks.

For example, let's assume a trader is using a one-minute chart and the highest price for stock in the last 20 minutes was $125.50. The lowest price in the last 20 minutes was $125. The indicator will draw an upper line at $125.50 and a lower line at $125. If a mid-band is added, it is drawn at $125.25.

Day Trading Strategies for Donchian Channels

Incorporate Donchian Channels into your trading by using strategies devised by others. You can also design your own strategies by testing out the indicator in a demo account first. Traditionally, Donchian Channels are used to identify breakout positions (the points at which prices move through a previous high or low).

The channels are generally most significant when identifying price movements between peaks and troughs in a stock's price. The channels are often used as a way to enter potentially emerging trends. In one strategy, you can use the indicator to buy long when the price moves above the average line—or short-sell when the price falls below the average channel line.

In another strategy, you might consider exiting if the price reaches the mid-band or the opposite side of the Donchian Channel after entry.

Variations of the Basic Strategy

Not all moves above the upper band or drops below the lower band warrant a trade. Add a trade filter, such as a moving average, to aid in highlighting the trend. Only take long trades if the price is above the moving average, and only take short trades if the price is below the moving average. 

During a steady uptrend, the price may pull back to the lower band. This is also a potential area to buy, since the overall trend is up. During a steady downtrend, the price may pull back to the upper band. As long as the trend is down, short trades can be taken near the upper band. The mid-band can also be used for such trade signals. 

Use a longer-period Donchian Channel for entries, such as the 20-period, then use a smaller period, such as a 15, for exits. This might require having two Donchian Channels displayed at the same time. Having two sets on the screen may make it hard to read and appear cluttered, so apply different colors to the different channels to distinguish them from each other.

You should buy when the price rises above the upper band of the longer period channel (20-period), and exit when the price falls below the lower band of the shorter period channel (15-period). Short sell when the price falls above the lower band of the longer period channel, and exit when the price rises above the upper band of the shorter period channel.

Find a Strategy That Works for You

Play around with the indicator settings to find parameters that align with the market in which you are trading. The channels may help in isolating times when potential trends are starting or ending. No indicator works well 100% of the time. Sometimes the market moves sideways. On those days, the trending signals produced by the indicator won't be profitable. 

Successful trading always comes down to testing out strategies before using them with real capital. Establish a strategy and test it out over many trades and days in a demo account. Then, only start using real capital if the strategy produces consistent profits during that time.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.