Capture trends with this simple Donchian channel strategy

May 30 2017, 9:15 am
Donchian channel strategy_3005

In last week’s article, we covered the basics of using the Donchian channel and a rather simple strategy in determining and trading breakouts with the indicator.

In this week’s article, we make use of the Donchian channel indicator and show you a rather simple way to enter a trend. This trading strategy can help you to not only enter the trend in the early stages, but it will also enable you to capture significant profits.

What’s simple about the Donchian channel strategy is that we do not use any other indicators. The strategy can be applied to any market and ideally on the 1-hour chart which can help day traders to make some decent profits.

The Donchian channel based trend trading system works on the simple concept of letting the winners run. The stops are usually small compared to the profit potential that one can realize using this trading strategy.

Applying some concepts of money management and position sizing, traders can also make additional profits while covering their risks at the same time, leading to more and more traders that are risk-free.

So, if you like a trend trading system that is simple to use, read on.

Applying the Donchian Channel Indicator

While the standard MT4 trading platform does not have the Donchian Channel indicator, a quick look at the website shows the MT4 indicator repository having the Donchian channel indicator.

Once you download the Donchian channel, apply the indicator to a 1-hour chart. Make sure to hide/disable the mid-Donchian channel, which leaves you with just the upper and lower Donchian channels.

Color code these lines to Red (for upper) and Green (for lower) as shown in the chart below.

How to trade trend with the Donchian channel?

For long positions:

  1. the first step is to determine if there was a downtrend previously by looking at lower highs
  2. Once you identify lower highs, look for the lowest high formed and mark that level with a horizontal line
  3. Then, simply wait until the lower Donchian channel breaks above the previous lower high
  4. Take a long position on that session’s high with stops at the most recent swing low.

It is ideal to enter with two individual positions. The trailing stop for the first position will be the lower Donchian channel, while the trailing stop for the second position is open, and closed out only when there is a reverse signal.

Example long position using the Donchian channel method
Example long position using the Donchian channel method

For short positions:

  1. Identify a prevailing uptrend with a series of higher lows
  2. Mark the previous highest low with a horizontal line
  3. Wait for the Upper Donchian channel line to break below the highest low and enter short on that session’s low
  4. Set stops to the recent swing high level
Example short position using the Donchian channel method
Example short position using the Donchian channel method

Understanding price action with the Donchian channel

The above trading strategy is actually quite simple logically speaking. We know that the Donchian channel is nothing but a 20-period high and low indicator that plots a continuous line, forming the Donchian channel.

Generally, Donchian channel trading rules are to buy or sell the 20-period breakout high or low. This trading system is vulnerable to some pullbacks and more importantly fake breakouts as well.

We can avoid this by using the Donchian channel’s high and low price bands as a filter.

An uptrend is clear when you see that the 20-period low is higher than the lowest 20-period high and price (and Donchian channels) continue to move in that direction. Likewise, a downtrend is when a 20-period Donchian channel high is lower than the most recent 20-period highest low.

Who is this trading system ideal for?

This simple Donchian channel based trading system is ideal for those who can be patient enough to wait for the right signals to occur. While normal profits can be expected, the system can be utilized to show higher profits when multiple positions are taken and profits booked at regular intervals.

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John has over 8 years of experience specializing in the currency markets, tracking the macroeconomic and geopolitical developments shaping the financial markets. John applies a mix of fundamental and technical analysis and has a special interest in inter-market analysis and global politics.

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