If you are looking for an indicator that can help you spot potential breakouts while also providing information about the volatility of a currency pair, you might consider plotting Donchian channels on your charts.
In this guide, you are going to learn the basics of Donchian channels. You will see how to draw and use them in Forex trading.
What are Donchian channels?
As the name indicates, this indicator plots a channel on your chart. It is named for its creator, futures trader Richard Donchian. He came up with an original technique for using channels back in the 1970s. Since Donchian channels are still used today, clearly his method stood the test of time.
When you plot Donchian channels on your chart, you will see three bands:
- Top band: The highest highs of the last n periods
- Bottom band: The lowest lows of the last n periods
- Central band: (highest highs of the last n periods + lowest lows of the last n periods) / 2
By default, most traders use 20 days as the period n, but you can experiment with any period you want.
Key point: Donchian channels consist of three bands. You can set any period you want for the calculations.
What do Donchian channels show?
Donchian channels give you a simple way to assess two different types of information: volatility and potential breakouts.
- Volatility: Is the channel narrow? If so, that tells you that volatility is relatively low. Is the channel wide? If so, that tells you that volatility is relatively high.
- Potential breakouts: When the price touches the upper or lower band of the Donchian channel, that can signal that you should buy or sell. More about how this works farther below.
Key point: Donchian channels help you visualize volatility and look for breakouts.
How to plot Donchian channels on a chart?
If you want to use Donchian channels, you will first need to grab the indicator. Some proprietary trading platforms might offer a built-in it, but it is not by default among the tools that MetaTrader 4 provides you. Indeed, not all traders are even aware that Donchian channels exist!
So, go look for a version of the Donchian channels indicator and download it. You can then proceed to use it in MT4. Here are the steps to displaying it:
- Attach the indicator to your chart.
- Set your preferred period for the calculations. It will probably say 20 by default.
- That's it! You should now see the bands on your chart, and you can proceed to look for trade opportunities (see below).
Key point: It only takes a minute or so to plot Donchian channels on your charts.
How to trade with Donchian channels?
Now that you know how to plot Donchian channels, let's talk about how you can use them to trade Forex.
When you plot Donchian channels, you can use them to spot potential breakouts up or down.
What you need to do is look for the price to touch the upper band or lower band. A touch on the upper band means Buy. A touch on the lower band means Sell.
This goes against instinct for some traders, who want to imagine the upper band means overbought, and that the lower band means oversold.
When should you exit a trade? Some people get out based on what is happening with the middle band. Others wait for the price to touch the opposite outer band.
So, for instance, let’s say that the price touched the upper band, so you went long. So long as the price bounces around above the middle band, you continue to stay in your trade. But if the price drops under the middle band, that may signal that the trend will soon reverse. So, you could get out of your trade at this point.
Alternately, you could stay in your trade and wait until it touches the bottom band. As that would constitute a signal to Sell, you would then get out.
It is recommended that you test different variations on these ideas for entries and exits and figure out what works best for you.
Key point: You can use touches on the upper band and lower band as buy and sell signals respectively. When price crosses the middle band, that can signal a reversal between bullish and bearish conditions (or vice versa, depending on the direction).
General tips for using Donchian channels in FX
- Do not assume that the top and bottom of the channels represent overbought or oversold conditions. We have already discussed this above, but it is such an easy mistake to make that it bears emphasis. If you want, you could always add another indicator to your charts that does measure overbought and oversold conditions such as a stochastic oscillator or Money Flow Index.
- Incorporate Donchian channels into a comprehensive strategy. It may be difficult to spot appropriate trade entries using nothing but the Donchian channels. You should think about pairing this indicator up with others or with a moving average so that you have confluence.
- Backtest and demo test. Whatever trading system you come up with, it is very important that you put it to the test before you start using it live. Backtest first to get an idea for what is likely to work, and then demo test to put it into practice with no risk. After you are profitable, you can think about trading with real money.
If you are interested in Donchian channel as a trading tool, you would probably like to try our free Donchian Ultimate indicator. It is an advanced version of Donchian channel with multiple settings to fit to your trading needs.
Conclusion
Donchian channels can help you get in on trends and reversals early. It can be difficult to see when a trend is forming or when a reversal is likely without a visual aid. Donchian channels can serve as that aid, helping you to identify potentially profitable trade setups. Many foreign exchange traders overlook Donchian channels or are not familiar with them, but you may discover that they are just what you need to provide confluence for your strategy.
If you want to ask questions about Donchian channels and their use in currency trading, feel free to join a discussion on our Forex forum.
