Basic Donchian Channel Trend Riding Forex Trading Strategy

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Basic Donchian Channel Trend Riding Forex Trading Strategy

Often, traders write-off indicators as lagging and would often profess that price action is king. While this carries a certain degree of truth into it, we also can’t discount the fact that some indicators do allow traders to better understand the markets visually rather than just judging things by their naked eyes.

This article is not geared towards the discussion or debate of the superiority of either indicators or price action, but rather to show how some indicators do support price action in a visual manner.

In my mind, one indicator does stand out in this regard – the Donchian Channel. This indicator which comes with the standard MT4 application is a hidden gem that many traders overlook. However, if studied carefully and observed, this indicator might just help some traders find their edge.

Richard Donchian, known as the father of trend following, was a well-known figure in the world of trading during the mid-1900’s. During those days, the currency markets were still non-existent, technology was not yet available to allow for fast and powerful computing, and trading using computers were still an unimaginable distant future. Given this scenario, Richard Donchian, who wanted to create something to make his trading easier, had to settle for something very simple. This simplicity I believe is the power behind the Donchian Channel.

So, what is the Donchian Channel? It is simply an indicator made of 3 bands which indicates the high, low, and its average for the past 20 periods. Below is a picture of what it looks like.

Donchian Channel indicator

 

  • Red Line: represents the highest high for the past 20 periods
  • Green Line: represents the lowest low for the past 20 periods
  • Blue Line: represents the average of the Red and Green lines

With just these 3 simple lines, one which could be computed in a time when computers were still unavailable, much could already be derived from this simple indicator.

  • Volatility

This indicator, by plotting the highest highs and lowest lows allows traders to see how far price could travel, which is basically volatility. Many professional traders know too well that without volatility they can’t make money. The Donchian Channel provides this information by showing if a market has the capacity to be volatile.

  • Short-Term Range

The Donchian Channel, also by plotting the highest highs and lowest lows in effect plots the range during the past 20 periods. This might not be too helpful for longer term traders, but this could be of value to short term traders. However, the MT4 also allows for a tweak in this indicator, allowing traders to change the number of periods it should be basing the highs and lows from.

  • Contraction and Expansion Phases of the Market

The Donchian Channel also shows how the market contracts and expands. Phases wherein the Donchian Channel is narrow would be considered as contraction phases, while phases wherein the Donchian Channel significantly widens would be considered as expansion phases. This is a very valuable information since rapid price movements often occur after contraction phases.

  • Price Action Based Trend

Perhaps the most valuable information that one could get from this indicator is the direction of the trend, and not only does it indicate the trend, but it is based on price action. Some price action traders might argue that this is not how price action is read. However, let me explain first why I see this as derived from price action. One of the ways trend is determined using price action is the use of higher-highs and lower-lows or vice versa. Charts showing higher-highs and higher-lows are considered bullish trending charts while charts showing lower-highs and lower-lows are considered bearish trending charts. Since the Donchian Channel is based on the highest highs and lowest lows for the past 20-periods, in effect it is shows whether a chart is trending or not. On the example above, you would see how the price creates lines that are ascending across the chart indicating that it is a bullish trending chart.

How to Trade the Donchian Channel

There are many ways to trade using the Donchian Channel, however I will be discussing one of the most basic ways to trade it.

Step 1: Determining the Trend

First, we are to visually determine the trend whether it is a bullish or bearish trending chart or plainly a ranging chart with no trend. For seasoned traders this will be easy to determine, but for some beginning traders, this might be difficult. To give us a clue, we could look at whether the long horizontal lines at the bottom are constantly getting higher, or at least the most recent horizontal green line is still above the major horizontal green line. This would be a bullish trending chart. On the other hand, if the chart has its highs, represented by horizontal red lines, getting lower and lower, it would be considered as a bearish trending chart.

What if the chart shows a horizontal green line higher than the recent horizontal green line, but also has a horizontal red line lower than the recent horizontal red line? This is not too much of a concern as this shows opportunity. This area is considered as a market contraction. We could expect the next phase to an expansion, which might just possibly be a trend continuation.

Donchian Channel forex strategy

Step 2: Wait for the Market to Expand

Of course, we wouldn’t enter the market mindlessly after determining the trend. In theory we could, but that wouldn’t be the most profitable route. So how do we determine for signs of trend resumption?

After price dives back below the middle blue line during the contraction phase, we are to wait for a candle to close back above it. It shouldn’t just be any candle, but it should be a big long candle indicating that there is force behind the shift in direction.

Donchian Channel forex system

Zoomed in, this candle right here with an arrow at the bottom is an example of a good entry candle. It broke and closed above the blue line and is a long big candle.

Step 3: The Trade Setup

Entry: Close of the breakout candle

Stop Loss: A few pips below the breakout candle

Exit: As soon as a candle closes below the blue line

Donchian Channel mt4 indicators

Conclusion

This strategy could be a very profitable strategy if done properly. The sample trade above would have gained 90 pips on the 1-hour chart. This shows the potential of the Donchian Channel as an indicator that visually aids traders doing trend riding strategies.

However, this strategy is not the answer to every trade that we take. As said earlier, this is a trend riding strategy. This would definitely not work in a choppy ranging market or a market reversal. Also, there could be some false signals if we are not careful in assessing the breakout candles. This is why it is important to determine whether the candle has force behind it or not. One tool that could be useful is the volume. Candles with high volume typically have force behind it.

This strategy serves as a framework which you can develop further in combination with other strategies and filters, as well as stop loss and trade management strategies.

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