Donchian Channel Explained

Definition of the Donchian Channels Indicator

The Donchian Channels are a set of custom indicators which were introduced by Richard Donchian. The Donchian Channels work a bit like the conventional channels in the MT4 platform suite, with just a few modifications. They are used as components trend breakout strategies. Since they are trend-following indicators, Donchian Channels work well in trending markets. Unlike their native channel counterparts, Donchian channels are not designed to work in range-bound markets, but doesn’t work well in a sideways channel.

Components of the Donchian Channel Indicator

The Donchian channel is a moving average indicator made up of bands that plot the highs and lows of price action over time. Usually three bands are seen on the channel indicator, but only two are used at any point in time, depending on whether the trader wants to trade long term or short term.

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The default setting of the lower and upper channels is a 20-period moving average. The middle line is the optional line.

Indicator Settings

The Donchian channel is a custom indicator. You must first add it to the indicators folder by using File -> Open Data Folder -> MQL4 -> Indicators. Then restart the platform and attach it to the MT4 chart by clicking on Insert -> Indicators -> Custom -> Donchian channels.

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In terms of appearance, some modifications to the indicator can be made. These modifications can be either to increase or reduce the line thickness of the lines or to change their colour to make them more visually observable. You can also decide to delete the middle band, depending on which trading strategy is being used. We have discussed a trading strategy using the Donchian channels in the Forex Strategies section of the site.

Usage of the Donchian Channels in Forex Trading

The Donchian channels indicator is designed to catch the trend and not to locate tops and buttoms. Therefore it is not a good tool for support and resistance trading per se. The trade signals derived with this indicator are based on the following rules:

  1. Go long on the asset when the price action closes above the Donchian Channel. This signal is also used to close earlier short positions.
  2. Go short when price closes below the Donchian Channel. This signal is also used to close out long positions that had been assumed earlier on.

The Donchian Channel indicator is not meant to catch tops or bottoms, only trends. Trend traders may want to extend the standard 4 week period to 8 weeks in order to wait for significant trend signals, while others may shorten the period to a more sensitive 1 or 2 weeks for liquidation purposes.

Donchian Breakout Trade

The Donchian channels indicator is used to catch trends. You therefore will need to use the indicator with other indicators that can either point to trend direction of trend momentum. One way of doing this is to add a long period moving average to show the trend direction, then add a momentum indicator to confirm the strength of that move.

The reference points for the Donchian channel indicator are the upper and lower bands. These are the bands that are used in setting up the strategy.

For the long trade, you would want the price to break above the upper band. You would also want the moving average you use to show that the trend is pointing upwards. Then you would like to see a situation where the momentum indicator confirms the move. The coloured MACD indicator, which shows a blue colour when the momentum for the move is up, is one good indicator you can use.

On the other hand, if the price action is declining, you would want to see the price action break below the lower channel line, then retreat a little with a pullback to the broken line, with the moving average pointing downwards to confirm a downtrend and your coloured MACD indicator showing a red colour to confirm that the momentum for a downward move is strong.

The snapshot demonstrates these two scenarios.

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