Donchian channels are a technical indicator used to measure the relative volatility of a financial instrument. Developed by writer, fund manager and trader Richard Donchian, their primary function is rooted in trend identification. Donchian channels are applicable to almost any financial product prevalent in the currency, futures and equities markets.
Known as the "father of trend following," Richard Donchian is widely credited as being a pioneer in the money management industry. He created the first managed fund in 1949, and championed a purely technical approach to the crafting of trading decisions. Price action, above all else, is the foundation of his market-based strategies.
Calculating Donchian Channels
Donchian channels are essentially a moving average indicator. However, instead of being represented as a single value, an upper and lower band is used to place current levels of volatility into the proper perspective. In much the same fashion as Bollinger bands, they are used to measure the elasticity or inherent volatility present in the pricing of a financial instrument.
Making the necessary calculations for Donchian channels is straightforward. All the user must do is determine a desired financial instrument and the periodicity for the study. The following is the basis for a 25-period calculation:
- Upper Band: 25-period high
- Lower Band: 25-period low
- Middle Band: (25-period high + 25-period low) / 2
The most important element of deriving a useful Donchian channel indicator is the period. Depending on the asset class and market, unique levels of volatility are present. As a result, upper and lower bands can be extraordinarily wide or narrow.
A period of 20 is commonly implemented, but values may be adjusted to reflect user preference and account for prevailing levels of volatility.
How Donchian Channels Function
Donchian channels are one of the more quantitatively simple, yet versatile technical tools available. They may be applied to different chart types and are put into practice as an overlay upon pricing data. As mentioned, the period may be readily adjusted to reflect the unique characteristics of a specific financial market.
An attractive feature of Donchian channels is that their application to the live market is intuitive. They can be especially useful in identifying the following characteristics of price action itself:
- Overbought: A market may be deemed overbought when price approaches or eclipses the upper band of the channel.
- Oversold: A market may be deemed oversold when price approaches or eclipses the lower band of the channel.
- Trend: Donchian channels may be used to identify or confirm a trending market. In a clearly trending market, price being in an overbought or oversold area acts as confirmation of the trend or a signal of possible strengthening.
- Breakout: A tightening of the channel, or a consolidation in the market itself, may be an indication of a forthcoming directional move in price.
In the event that one or more of these elements are present, Donchian channels may be used for market entry or to actively manage open positions.
Donchian channels are only one of the contributions made by Richard Donchian to the arena of active trading. His work is championed by many household names of the financial world, with one of the most well-known being the 1980s success of the Turtle trading group.
Several of Donchian's general market guidelines are considered the backbone of modern technical trade theory. The following are a few of the most commonly referenced:
- Beware of acting immediately upon public opinion.
- Limit losses and ride profits ahead of all other
- When market state is uncertain, small positions are advisable.
Donchian channels are a simple and powerful analytical tool. When used with other technical indicators, or in conjunction with market fundamentals, they can be useful in determining market entry and active trade management.