The Donchian Channel for Swing Traders
I’ve already published a couple of YouTube videos on the Donchian Channel. I thought it would also be helpful to you to see a detailed blog post on its tactics and strategies and how the Donchian Channel compares to other indicators.
In the swing trading strategies post, I went through some of the most commonly used chart-based swing trading strategies. If you’re looking to automate your trading decisions, the CA One Portfolio I’m trading has been coded into Python and is executing trades directly into the Coinbase Pro platform. You can follow the trades in eToro.
In the swing trading strategy post, I didn’t cover the Donchian Channel, so I did the videos and wrote this. Like all swing trading strategies, as I’ll explain below, the Donchian Channel needs to be tweaked, so it works for you.
I realize this is easier said than done. Newer swing traders develop their strategy through trial and error.
It’s frustrating and can be stressful. Sometimes, losing money on trades can trigger emotional responses from deep-seated views the swing trader has of money.
If a trade works out and is profitable, the swing trader might conclude they’ve found their strategy.
However, swing traders can do the right thing and still lose money on the trade. Or, they can do everything wrong but still make money on a trade. This example is just random good luck which isn’t a trading strategy.
Swing traders have blind spots everywhere, and it takes an awful lot of self-reflection to change this. If you’re starting with swing trading, and you’re finding it tough, I feel you. I’ve been there.
I’ve written elsewhere about my journey to finding my own swing trading strategy. Like most swing traders, at the beginning, there were lots of highs and lows.
I started trading at the end of the dot com bubble when every stock was going up several times in value. It was probably the worst time to start. It felt easy, I had no strategy but I didn’t need one – pick a stock with a name with dot com in its name, close your eyes and you’d make money.
In hindsight, even though I didn’t know it, I was probably following a strategy similar to the Donchian Channel strategy. It aims to capture trends in price, using price break above or below previous highs or lows as the trigger for entry.
What are Donchian Channels?
The Donchin channel is a technical analysis indicator that uses only one input, price. It’s comprised of three different lines.
The top line shows the highest point price has reached during the previous n number of trading days. The bottom line is the lowest price seen in the same n number of days. The middle line is the midpoint between the two lines.
‘N’ can be any number you want, it can be a weekly, 5-day breakout, or it can be 40 trading days as used by the Turtle trading system made famous by Richard Dennis.
Alternatively, the trader can go much longer-term. They might use a 100-day breakout, triggered if the current price crosses the highest or lowest price for the previous 100 days.
The length of time the trader is comfortable holding a position influences the breakout number; Trend followers aim to capture long-term price trends and are interested in breakouts above or below significant price points such as monthly or quarterly highs or lows.
Swing traders like myself and many readers of this blog will look to the medium term, might use a number between 5 and 40.
As I’ll explain, the Donchian Channel has limits and will have limited use by traders who aim to capture intraday price action when day-trading.
In a moment, I’ll detail how to calculate the Donchian Channel, but most charting software packages such as Tradestation or Thinkorswam will calculate it automatically and offer the Channel alongside a range of other technical indicators.
Donchian Channels Calculation and Formula
The above is the price chart of the Gold futures contract overlaid with the Donchian Channel.
The top, upper line in red, is the highest price in the previous 50 trading days. The lower line in blue represents the lowest point price has reached in the last 50 trading days. The light gray line in the middle is the mid-point between the upper and lower.
The indicator seeks to identify bullish and bearish extremes that favor reversals and higher and lower breakouts, breakdowns, and emerging trends.
The middle band computes the average between the highest high over N periods and the lowest low over N periods, identifying a median or mean reversion price.
Calculation and Formula
- Choose the time period (N).
- Compare the high print each day during that period.
- Choose the highest print.
- Plot the result.
- Choose the time period (N).
- Compare the low print each day during that period.
- Choose the lowest print.
- Plot the result.
- Choose the time period (N).
- Compare high and low prints for each day over that period.
- Subtract the highest high print from the lowest low print and divide by 2.
- Plot the result.
Donchian Channels Trading Strategies
There are several tactics the swing trader can take when using the Donchian Channel.
As I said at the start, you have to work out what fits your personality and account size. Tactics will vary on how they impact the starting account size.
Backtesting the strategy will go a long way to answering this question for you.
Remember, a commodities trader developed the Donchian Channel, and at the time, he was using end-of-day, daily close data.
The Donchian Channel helps traders make trading decisions using end-of-day data generated at the end of the day once the markets have closed. Of course, they can enter the market on a buy or sell stop placed above or below the high/low or the last n number of trading days.
The stop will be triggered intra-day when and if the price breaches the high or low.
However, the Donchian Channel wasn’t designed with intra-day trading in mind. During the trading day, there can be a lot of random price changes. Using minute or hourly highs or lows as the trigger can lead to lots of false breakouts and the risk of overtrading.
On the subject of day trading, I no longer trade intra-day because it requires a massive amount of screen time during the day for very little return on capital.
It didn’t make sense that I was putting so much emotional energy into day trading when the potential for profit was so limited.
Big swings in the price can happen overnight or over the weekend and it is those price changes that attracted me to trading in the first place. With that said, let’s return to the Donchian Channel and three strategies you can use with it.
Strategy 1: Always In
The ‘always in’ strategy means the trader always has a position, either long or short.
In the above chart, the first signal fires along in mid-July 2020 and will keep you long for several months until the beginning of October 2020.
At this point, the trader has a signal to go short. The trader will need to sell to close their long and then sell a second time to go short.
Up until now, the trader has sat through several months, tieing up capital and seeing the unrealized profits they had at the end of August disappear.
If you were the trader, how would you feel about that? Probably not great. However, when you trade a strategy like this, you agreed to frustrating periods, often for weeks at a time. All strategies have implications, so as an open question, what emotional payback does your strategy offer you?
You’re now short, but the price immediately gives an unrealized loss. The worst of it is in mid-November 2020.
Until late February 2021, the system keeps you short through several months of directionless trading.
You then have a buy signal, and you now need to go long. You need to offset your short position with a buy and then buy again to create your long. You remain long for several months, which sees significant unrealized profits on the account.
The price chart is the Robusta coffee futures contract, but it could be any stock or ETF, or forex cross.
Some markets will perform better than others, and trends can form anytime and in any market. By backtesting on a portfolio of 15, 20, or more different futures markets, stocks or ETFs, or a combination, the strategy will give performance metrics based on how it would have performed collectively.
Out of the portfolio of 20 markets, it may be only 3 or 4 markets that contribute to the alpha of the strategy – the above-average returns. The others markets will see losses or breakeven returns.
Don’t get hung up on the strategy’s performance on an individual market. Instead, look at a sample of trades across a portfolio of markets.
Of the 3 strategies I’ve covered, I’ve backtested the ‘always in’ approach.
So how did this strategy perform?
The above is a screen shot of the key metrics from the test.
The test was carried out across a portfolio of futures markets, including Gold, Oil, and mini S&P500, and used 30 years of data.
You can see the Compounding Annual Return is only 5.446%, with a relatively large Drawdown of 25.5%. The results also show only 38% of trades were profitable.
New swing traders who look for strategies with win percentages higher than 50% might be surprised by how small this number is. However, this is a relatively ‘normal’ number. The strategy is still profitable because the Average Win is 1.44% compared to the Average Loss -0.60%, 2.4 times bigger.
Strategy 2: Protective Stop
The second tactic the swing trader can take is to use a protective stoploss.
A protective stop-loss order will be entered simultaneously as the opening trade to buy or sell.
The broker will only execute the stop-loss if the instrument’s price reaches the trader’s trigger level.
Only if the price reaches the trigger level will the stop-loss be executed. If this happens, the stop-loss becomes a market order to buy or sell.
Managing financial risk like this is also a way for a trader to manage the impact losing trades have on their emotional constitution.
This market order will offset the original trade to buy or sell; long trades will be sold, and short trades will be bought.
The above image is the Donchian Channel placed on the Japanese Yen futures price chart.
I’ve used the Average True Range (ATR) to determine the stop-loss position in the above example.
I won’t go into detail here, but the ATR fluctuates according to the distance between the highest price and lowest price seen during the trading day.
We could be referring to the Japanese Yen futures contract or Apple stock, or Bitcoin. It’s irrelevant what the market is since the principle is the same.
As the difference between the highest and lowest price point changes, so will the ATR. It should be evident that more significant differences between the two prices mean more volatile prices.
The trader can choose a multiple of the ATR to determine the stop placement. One * ATR means the stop will be below (for longs) or above (for shorts) by the distance of the ATR. For example, assume the trader buys Microsoft stock (is long) at $200 and the ATR is 200. That’s 200 cents or $2, so the trader’s stop will be at $198.
Of course, the ATR changes from day to day, but the trader will use the given ATR on the day they enter the trade.
The larger the multiple of the ATR, the greater the distance between the entry point and stop loss. There becomes less chance the stop-loss will be triggered.
However, the trader will be accepting more financial risk. The trader must also consider their account size and where the instrument is in its volatility cycle.
I explain the volatility cycle further in my Swing Trading 101 course, but in essence, greater volatility brings a greater chance the trader will lose on the trade. A tactical change needs to happen here, and position sizes will have to be adjusted.
Strategy 3: Counter-Trend
In contrast to the above two strategies, strategy 3 tells the trader to be short when the Donchian Channel signals long. Conversely, when the Donchian Channel tells the trader to sell, he will do the opposite and buy.
I haven’t backtested this strategy, but the hypothesis is that markets spend most of their time trendless. You can look at the price chart for a stock for weeks at a time, and there will be no discernable trend.
Suddenly, a trend will form, and the price will quickly move up or down towards the upper or lower lines of the Donchian Channel.
Check out the price chart of the Euro FX futures contract. This price chart could be a stock, ETF, cryptocurrency, or future; it doesn’t matter the point is true for all instruments.
To my eye, there are three phases of note.
In the first phase, the price trends towards the upper Donchian Channel line. There’s a period where it pauses and pulls back slightly, but the trend then resumes.
In the second phase, the price touches the upper Donchian Channel several times.
Each time would take the trader long or confirm the existing long position. However, the price doesn’t move up with confidence. Instead, it bounces back down slightly.
After the last long signal, the price drops down significantly and moves into the third phase.
After initially trending up in new price highs, a similar pattern emerges. The Donchian Channel repeatedly gives long signals only for the price to then reverse.
After the last signal, the price falls over the following weeks and bounces off the lower line.
The Donchian Channel then signals a short trade, but the price immediately reverses.
You can see how using the Donchian Channel but taking the opposite trades as given could produce some attractive returns.
Such a strategy would need a stop-loss such as the ATR covered above and might see many losing trades.
However, the profitable trades appear to be significantly greater than the losing trades. Based on this chart, you might be tempted to research this further.
Again, backtesting the strategy would tell you whether it’s a viable one.
Final Thoughts: Working With Your Emotional System
Trading a Donchian Channel strategy using end-of-day closing price data means the trader is looking at the market from a high level and ignoring intra-day fluctuations.
An always approach means less trading and more waiting which might not be the reason people are drawn to trading.
Such an approach can easily blow up a small account so I would always use a stop-loss.
It’s a nice feeling going to sleep knowing my losses are limited but I still benefit from large price changes overnight or over the weekend.
However, placing a stop-loss close to the entry point might feel ‘good’ and bring some reassurance, however, you need to consider the implications.
Is the stop-loss too close and are you likely to lose on the trade just because of ‘normal’ daily fluctuations in the price? Remember losses like this still show up in your trading metrics and can undermine what might be a valid strategy.
Keep in mind also, that it might seem like a strategy with a win percentage of over 50% is better than one with 38%.
However, the trader has to consider other metrics before making any conclusions. Remember also, what is ‘better’ means different things to different swing traders.
As I’ve already mentioned, strategies come with demands on your emotional make-up.
Consistently implementing the strategy day after day will require skills that you might not have yet developed. Another trader might already have those skills.
Evolve your strategy to fit who you are like a glove while working on yourself to ensure you enjoy wearing the glove.
As you continue to work on yourself and your emotional intelligence, you will find you can consistently execute the buy/sell orders as given by the strategy. Similarly, you will have evolved your strategy in response to how you feel about implementing the strategy every day.