Developed by Richard Donchian, also known as the Father of Trend Following, the Donchian Channel is a moving average indicator that’s simple to use and packed with valuable information.
The Donchian Channel helps identify breakouts or overbought/oversold market conditions and measure overall market volatility.
This is accomplished via plotting 3 bands to formulate a price channel:
- Highest high (1)
- Lowest low (2)
- Mean of highest high and lowest low (3)
The highest high and lowest low are determined via a user defined period. Meaning, the next highest high, or lowest low will be plotted within the “N” period. By default within NinjaTrader the Donchian Channel period is 14, however defining the value of the period is up to the trader.
Due to its simplicity, the Donchian Channel is often incorporated into trading strategies and it can be used on virtually any market and on any timeframe.
Interpreting the Donchian Channel can be simplified into two factors:
- Narrow Channel Bands – low market volatility (4)
- Wide Channel Bands – high market volatility (5)
- Price action moves above the upper band can possibly signal long positions. Additional higher highs can signify a bullish trend.
- Price action moves below the lower band can possibly signal short positions. Additional lower lows can signify a bearish trend.
Similar to a number of trend trading indicators, the Donchian Channel is subject to false signals from dramatic market swings or whipsaws. Traders should consider using additional complimentary indicators to help with trend confirmation. Indicators such as a Moving Average or RSI when used in conjunction with the Donchian Channel can act as a possible trade confirmation tools. Nonetheless, no matter ones trading system, proper risk management and protective stops are paramount.