Technical Analysis Dictionary - Donchian Channel

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Technical Analysis Dictionary - Donchian Channel

Channels are a trading favorite because they define general boundaries within which most of the price action should occur.  Then flow of prices within a channel has been compared to a river in a valley.  When the river reaches one side of a valley, it  turns back toward the center or perhaps even the opposite side of the valley, depending on the path of least of resistance.  Like a river, prices also will occasionally jump their channel banks when there is a torrent of buying or selling.

A trendline and a parallel channel line form a straight-line channel. A channel that flows more like a river typically is produced by some type of moving average (or averages).  A less familiar type of channel is known as a Donchian Channel, named after Richard Donchian, a pioneer in developing technical analysis techniques and managed futures funds going back to the 1940s.

The basis of the Donchian Channel is rather simple: The high close and the low close for the last N periods form the upper and lower boundaries of the channel.  The accompanying chart uses 20 days for the June S&P e-mini contract, but you can vary that parameter to modify the channel for quicker or slower turns as you would with other channels.  The middle line of the channel is not a moving average but the mid-point between the high and low closes.

Analysis of the Donchian Channel is similar to other channels. In general, the channel helps you see where you might expect to find support and resistance - in this case, based on actual high and low closing prices for a specified period rather than a percent variation from a moving average as is the case with some other channels.

The direction of the channel is important.  If it is pointing down, trade from the short side, selling on rallies to the upper side of the channel or to the mid-point line and buying back on a return to the lower boundary.  If the channel  is moving up, trade from the long side, buying on dips to the lower side of the channel or to the mid-point line and selling on a return to the upper boundary.

As the chart illustrates, a Donchian Channel is not a one-way ticket to riches any more than any other technical analysis tool.  When prices hang along a boundary  for an extended period, as they did in February-March, you have to use some judgement, other technical signals and perhaps trailing stops to get into or out of a position. The transition period from down to up provides another challenge in April.

One approach would be to use the mid-point line as your trigger point. When prices fall below the mid-point, sell (February); when prices cross above the mid-point, buy (April).  Of course, that approach has the same problem as many others in choppy, sideways conditions.

With channels, you often get a second chance to buy or sell as the market tests its boundaries and then reverts back to a more normal mid-point position, but keep  in mind that a channel is only a guideline.  For better signals, you should combine the use of a channel with a technical indicator that highlights divergence with prices.