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Explained: What Is Donchian Channel & How To Trade With It?

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We use technical analysis indicators to understand the market’s current situation by smoothing out volatility noise and giving them clues about potential future moves. While some indicators focus on the trends and volatility, others usually revolve around a trend’s momentum. However, there is a simple and multifunctional indicator that touches upon all of the mentioned aspects— the Donchian Channel.

Yes, this technical analysis indicator is more commonly used in the traditional market, but it’s equally applicable in crypto markets, including derivatives futures trading. In fact, the founder (Richard Donchian) itself is a futures trader, which proves it works exceptionally well for hedging or trade speculation.

Donchian Channel is arguably similar to Bollinger Bands, particularly with its three separate lines. But it mainly focuses on identifying the high and low extremes that may lead to reversals, breakouts, breakdowns, and trends.

All in all, Donchian Channel is a volatility indicator that resembles a fluctuating channel when plotted on the price action. It mainly helps traders to visualize the resistance and support levels based on the recent highs and lows. Hence, enabling traders to understand the volatility of a price better.

The best part? It is one of the simplest trading indicators suitable for novice to advanced traders, and its versatility makes it applicable to all markets, including cryptocurrency.

Here is what it looks like on the chart:

Donchian channel patterns overview

How Does Donchian Channel Works?

Of course, you’ve heard of Relative Strength Index (RSI) or Bollinger Bands (BB), but did you know Donchian Channel has already developed about six decades ago by a famous commodity and futures trade. And the reason it was created is mainly to help traders determine asset’s price volatility and to spot breakouts critically.

However, little did you know this indicator does more than that. Best of all, it also determines the price trend and points to its momentum. And the channels are best to indicate the strength of the current market— bullish, bearish, or ranging.

Even though Donchian Channel is a lesser-known indicator, it does not mean that beginners should ignore it considering how multifunctional it is.

Just like BB, Donchian Channel is also made up of three lines, where the upper and lower bands represent the highest high and the lowest low of the previous period, respectively. While the centerline (median line) shows the average of the current high and low for that given period. The centerline is calculated by subtracting the highest high from the lowest low of a candlestick pattern on a price chart and dividing the result by two for the average. A good note here is the wider the two extreme channels, the more volatile the market is.

But what really differentiates Donchian Channel from Bollinger Bands? Here’s an overview.

Donchian Channel vs. Bollinger Bands

First of all, for the untrained eye, Donchian Channel and Bollinger Bands look almost identical. But beyond the similarities, Donchian Channel is different because it doesn’t require any users’ input for volatility. Another major difference lies in the calculation of these two indicators. While the Donchian Channel indicator displays the highest high and lowest low over N periods, Bollinger Bands display a simpler moving average (SMA) as the middle line and two standard deviations for each of the upper and lower lines. 

In a calmer market, Bollinger Bands are narrower than Donchian lines. However, during extreme volatility, the bands can go beyond the Donchian Channel’s lines. You can check the two indicators overlapping each other – the Donchian Channel indicator has a blue background, while the area of Bollinger Bands is colored with red:

Donchian Channel vs Bollinger Bands

Well, we don’t deny that it’s indeed messy at first when trying to understand Bollinger bands and Donchian Channel’s differences. But you can still notice that the two indicators act a bit differently. Specifically, the bands tend to react more promptly and follow the price, while Donchian Channel is slower, as it remains with the recent high or low until the period is updated. Note that the period for both indicators, in this case, is identical – it’s 20, which comes by default.

Donchian Channel vs. Price Channel

Another factor we’re often confused about is the difference between Donchian Channel and Price Channel. Again, most traders love to draw price channels, which are made up of two lines linking the recent highs and lows. However, the Donchian Channel is a bit different because it inclines horizontality while the price channel lines used by traders are always following the direction of the trend in a more visible way.

For example, in the image below, the two green lines represent a bullish channel’s resistance and support levels. If you check the Donchian Channel, it behaves as if it is lagging.

Donchian vs Price Channel

Both types of channel interpretations can provide accurate buy and sell signals, especially when used combined with other indicators, such as volume or some of the oscillators.

But, if you still doubt if Donchian Channel works for crypto trading, here’s what you must know. Not only this indicator works perfectly in analyzing the extremely crypto volatile market, but it also spots the breakout points for traders to open long or short positions more accurately. 

How to Use the Donchian Channel Indicator in Crypto Market?

Donchian Channel can be used in many ways, as the indicator has multiple attributes. First of all, crypto traders can analyze the market and every aspect of the ongoing friction between bulls and bears. Next, traders would be interested in employing the indicator in the trading process. Precisely, to spot the entry and exit points of long or short positions.

Here are the primary contexts and strategy ideas where Donchian Channel may be used successfully:

Market Volatility

Donchian Channel is regarded as a volatility indicator for its capability to display price volatility accurately. By determining the market’s volatility level, you can easily decide whether to open a position or otherwise. Besides, it helps to prepare you to react accordingly to extreme changes. For example, if the price is in an up-trend (bulls) during low volatility, the chances are that the ascending move will continue for a while.

For momentum traders, this is an excellent opportunity to go for a long position. When the volatility increases, the market may become more unpredictable, but this is another great chance to open positions, though the approach should be different.  

Breakout Trading

One of the most popular ways to use the Donchian Channel indicator is to apply it with breakout trading. However, the two main types are breakdown as trading breakouts of the upper or lower channel lines or trading breaks of the center channel line in both directions. In a nutshell, cryptocurrency traders use it to search for signals to open long or short positions. 

The signals can be observed every time the channel’s upper line goes higher than the previous high, in which case a long position can be considered, or when the lower line goes lower than the previous low, in which case trades go short. In other words, the positions are opened when the price is breaking above or below the extremes of the channel. That suggests the trend will continue in that particular direction for a while. It’s because the upper and lower bands act as resistance and support levels, respectively.

Middle Line

Besides the channel’s extremes, the centerline can also provide decent signals. Suppose a cryptocurrency is trading close to the midline without noticeable deviations toward the upper or lower band. In that case, we may assume that the price is currently experiencing low volatility, and there is no clear trend at the moment. In this case, the channel would narrow.

However, if the market is trending towards the upper band, it makes sense to think about a long position and benefit from the ascending move. If the momentum is inclining towards the lower band, traders can go short.

But how to apply? Here’s an example. 

An Example of Donchian Channel Strategy

Of course, the Donchian Channel strategy can be used for any trading asset, including cryptocurrencies. This strategy has some well-defined trading rules, which should delight beginners. For the sake of simplicity, we’ll explain the strategy with the bullish case scenario. Though, it is applicable in bear markets as well. 

According to this strategy, when the cryptocurrency price oscillates within the channel, the market will begin to crawl along the upper line. That can end up with the price breaking above the channel. Now, here are the rules that you should consider for opening and managing a position:

Step 1: Insert the Donchian Channel indicator into the chart

You should start by placing the indicator on the chart, which is preferably a candlestick one. Most trading platforms and price chart services provide this indicator. The default parameters with 20-periods are ideal for us, so we don’t make any changes to its settings.

This strategy rather suitable for day trading and intraday trading, so you should consider trading on 15-minutes, 30-minutes, and one-hour timeframes. In the first case, the indicator will show the highest high and the lower low of the last 5 hour candles (15 minutes * 20), and so on.

Step 2: Wait for the price to crawl along the upper line

The next step would be to wait until the price clearly moves along the channel’s upper line for a while. During this period, the price should never go below the centerline (median line). In other words, the price should adhere to the Donchian Channel’s upper side. That demonstrates that the bullish momentum is robust, as demand for the cryptocurrency is increasing. Here are several instances when it happens: 

Donchian Momentum Bullish Momentum

Step 3: Go long when the price pulls back

While you may think that we should go long while the price is crawling along the upper line, our strategy has different rules. Instead, we should wait for a pullback during which the price action moves to the middle. We should open a long position when the price breaks below the centerline or when it touches the lower band.

In fact, you can open a long position when the price pulls back to the middle line and then open a second buy order when the price retreats further to the lower band. If it bounces back right after breaking below the centerline, there is no need for a second buy order. In this way, we will apply an effective risk management technique.

Price pulls on Donchian Analysis

Step 4: Setting the stop loss

Another important risk management step is to place the stop-loss order, which should be set below the lower band of the Donchian Channel indicator. The stop loss will prevent any further loss in the case the price goes against you.

Stop loss on Donchian

Final Step: Setting the take profit 

Suppose the bullish trend continues until the end of the day, you should exit the market at the end of the day. As you don’t want to be exposed to overnight risks. Still, the price might correct before the end of the day. And in this case, you will have to exit the market manually or better use a take-profit order, which will help you save time and don’t bother monitoring the trade every minute. For this strategy, you can use a trailing take profit that will move along with the price.

That’s it! You can test the strategy on a demo account before implementing it with real funds. The great thing about it is that it uses several risk management techniques to minimize potential losses as much as possible. As mentioned, you can use the same rules during bearish markets, in which case you will open short positions.

Mistakes to Avoid When Trading with Donchian Channels

One of the biggest mistakes of day traders who use the Donchian Channel indicator is trying to determine the overbought and oversold levels with it, which is wrong. These traders believe that if the price is moving close to the upper band, it means that the market is overbought and should definitely retreat soon. Some traders can even open short positions when the price touches the upper band. However, the uptrend may continue for much longer, leaving the mistaken trader with insufficient funds to maintain the position.

Instead, one can use the Relative Strength Index or the Stochastic oscillator to get better signals about the market’s potential overbought or oversold levels. Otherwise, the trader is likely to blame the Donchian Channel indicator for providing inaccurate or false signals, which is not true.

The Final Note

In conclusion, the Donchian Channel indicator is very similar to Bollinger Bands. In terms of appearance and can be used in multiple ways, which is excellent for both beginners and advanced traders.

Most cryptocurrencies are highly volatile and require adequate indicators to provide a glimpse of the market’s actual state.

Also, you can pay close attention to the strategy that we shared as an example. It has a significant risk to reward ratio and has been tested multiple times on various assets. Still, it would help if you started practicing it on a demo account or checking the historical price. Good luck!

*This article is intended for and only to be used for reference purposes only. No such information provided through Bybit constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific person. These forecasts are based on industry trends, circumstances involving clients, and other factors, and they involve risks, variables, and uncertainties. There is no guarantee presented or implied as to the accuracy of specific forecasts, projections, or predictive statements contained herein. Users of this article agree that Bybit does not take responsibility for any of your investment decisionsPlease seek professional advice before trading.

Disclaimer

This article is intended for and only to be used for reference purposes only. No such information provided through Bybit constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific person. These forecasts are based on industry trends, circumstances involving clients, and other factors, and they involve risks, variables, and uncertainties. There is no guarantee presented or implied as to the accuracy of specific forecasts, projections, or predictive statements contained herein. Users of this article agree that Bybit does not take responsibility for any of your investment decisions. Please seek professional advice before trading.

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