What is Donchian Channel and how does it work?

During the 1950's a trader called, Richard Donchian formulated the Turtle Trading system. The same system later on formed the basis for an indicator called the Donchian Channel.

Donchian Channel is a volatility indicator that shows overbought/oversold conditions in security and helps predict possible breakouts and breakdowns.

Just like other channel indicators like a Bollinger Band or Keltner channel, the Donchian Channel also has three bands enveloping the price. However, it differs from other channels in the way these bands are calculated. While Bollinger Band uses concepts of Moving average and standard deviation to plot the channels, Donchian channels use a stock's Highest high and lowest low prices over a period to plot the channels.

Let's understand this indicator in a bit more detail.

How is a Donchian channel plotted in a chart?

As stated earlier, the Donchian Channel has three bands just like other channels, the difference being the way these bands are plotted. The upper band of the Donchian channel is the highest high of a stock over a period. The default setting of a Donchian Channel is 20 period, so the upper band represents the highest price the stock has traded in this 20 period. The period here can be day, week, hour, or whatever you set the chart parameters to. So, in a daily chart, the upper band represents the highest price the stock has traded in the last 20 days.

Similarly, the lower band in the Donchian Channel is the lowest price the stock has traded over a specific period. Since the default setting of the indicator is 20-period, so lower band represents the lowest price the stock/security has traded in the last 20 bars.

The middle line or band is a simple arithmetic mean of the upper and lower channels. So, to calculate this band all you have to do is add up the values of the upper and lower bands and divide it by two.

Now let's take a look at the Donchian Channel in a chart.

 

In this daily chart of Reliance you can see a band enveloping the price, these are bands of the Donchian channel. The upper band is the highest high price of the last 20 days while the lower band is the lowest low for the same period. These bands have been shown by blue lines above and below the price in the chart. The middle band is formed by calculating the simple average of these two lines. This is shown by the red line in the middle of the band in the chart.

Now that you have a foundational idea about the Donchian Channel and how it looks like in a chart, let's quickly move on to the interpretation part.

How to Interpret the Donchian Channel?

Traders look for instances when the price touches either the upper or lower band of the channel. However, the interpretation of the Donchian channel depends on the prevailing trend. So, price touching the upper band will have different meanings depending on whether a stock is in an uptrend, downtrend, or sideways trend. We will take each of these trends separately and will see what Donchian Channels indicate in these different trend situations.

In an uptrend, the price touching the upper band of the Donchian channel means that the stock is overbought and might correct toward the midline. While price touching the lower band might signal a possibility of reversal to a downtrend or at least a sideways trend.

Let's see this in a chart.

 This is a daily chart of BHARTI AIRTEL. As you can see in the chart, the stock is in uptrend and touches the upper band of the Donchian Channel several times. Also, notice that each time the price touches the upper band of the channel it tends to come back towards the midline before again continuing on its northward journey to the upper band.

This is a daily chart of TATA STEEL.

On the left-hand side of the chart, you can see that the stock was in an uptrend as shown by a black arrow. Then the stock touches the lower band of the Donchian Channel, as indicated in the chart. Notice that afterward, the stock reversed to a downtrend.

Now that you know how to interpret the Donchian channel in an uptrend, let's move on to a downtrend now.

 In a downtrend, price-touching the lower band means that the price is overstretched on the downside and it might make a corrective move up towards the middle band. A stock in a downtrend and touching the upper band of the Donchian channel means that there might be a possibility of a reversal or the price going sideways.

Let's see this in a chart.

In this chart of VEDANT FASHION shown alongside, you can see that the stock was in a downtrend and every time the price touched the lower band it went up towards the middle line.

Also, notice that once the price touches the upper band of the channel, the price goes sideways before reversing to an uptrend.
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Now let's come to the sideways trend.

In a sideways trend, the price touching the upper band should be inferred as a possibility of a breakout while the price touching the lower band suggests a breakdown. However, this should be confirmed through price action to make the signal more reliable. For example, the price touching the upper band and simultaneously price breaking a resistance level might be a better setup to take entries.

Let's see this in a chart.

In this daily chart of HDFC BANK, you can see that the stock was in a sideways trend briefly as shown by a purple rectangle on the left-hand side. Notice that once the price touches the upper band and simultaneously breaks a resistance level, the stock goes upwards. 

Now I hope you have a fair idea about the Donchian Channel. You also learned how to interpret this indicator in relation to price and how by bringing trend perspective into the interpretation a better judgement about future price movements can be made. 

Donchian Channel is a useful indicator but like any other indicator, it should never be used in isolation. By bringing things like price patterns, chart patterns, and some other indicators into perspective better trading decisions can be made.

This would be the subject for future posts where you will learn some trading strategies using the Donchian channel, so stay tuned. You can also watch this Youtube video to understand the basic concepts of  Donchian Channel.