Firetip X: Donchian Channels
What are Donchian Channels?
The Donchian Channels are in indicator displayed as three lines on a chart, derived from moving average calculations. There are three parts of the Donchian Channel indicator; the upper, middle, and lower bands. The upper band marks the highest price of a futures or options contract over X periods, while the lower band marks the lowest price of the futures or options contract over X periods. The area between the upper and lower bands represents the “Donchian Channel”. Well-known futures trader Richard Donchian developed the indicator in the mid-twentieth century to assist him in identifying trends.
What is the Formula?
UC = Highest High in Last N Periods
Middle Channel = ((UC – LC)/2)
LC = Lowest Low in Last N Periods
UC = Upper Channel
Period = Minutes, hours, days, weeks, months, ticks
N = Number of minutes, hours, days, weeks, months, ticks
LC = Lower Channel
What Can Donchian Channels Tell Us?
The Donchian Channels help to identify comparative relationships between the current (last) price and trading ranges over past predetermined periods. The three values build a visual map of price over time, similar to Bollinger or Keltner indicators, indicating the extent of bullish and bearish price action for the chosen period. The top line identifies the extent of bullish energy, showing the highest price traded for the period. The center line identifies the median or mean reversion price for the period, showing the middle ground traded for the period. The bottom line identifies the extent of bearish energy, highlighting the lowest price traded for the period.
Donchian Channel Trade Signals
Above is a daily chart of the E-Mini S&P 500. The Donchian Channels are most commonly used on a daily chart, with a 20 period (20 day) look back.
A buy signal (green circle) occurs when the the market touches the upper band of the Donchian Channel. This establishes that a new 20-day-high has been traded, and that a bullish trend might follow.
A sell signal (red circle) occurs when the market touches the lower band of the Donchian Channel. This establishes that a new 20-day-low has been traded, and that a bearish trend might follow.
The Limitations of the Donchian Channels
Markets move according to many types of activity. An arbitrary N period value for the Donchian Channels may not reflect current market conditions, generating false signals that can negatively affect trading and investment performance.
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DISCLAIMER: There is a substantial risk of loss in trading commodity futures and options products. Losses in excess of your initial investment may occur. Past performance is not necessarily indicative of future results. Please contact your account representative with concerns or questions.