Richard Donchian was a futures trader, who is attributed with creating the popular Donchian Channel Indicator. Richard Donchian is referred to as the grandfather of trend following.
The Donchian Channel is formed by using the greatest high of x number of days, and the lowest low of the same x length of time, then marking the spot between those values on your chart.
The Donchian channel is a practical indicator for observing the volatility of a stock. When a price is stable the Donchian channel will be reasonably slim. When the price fluctuates considerably the Donchian channel is going to be much wider. Its primary use, however, is for giving signals for long and short positions. If a security trades above its highest n day high, then a long trade is made. When it trades below its lowest x day low, then a short is established. They are invaluable for predicting support and resistance price levels from an objective point of view.
How It Is Employed
The Donchian Bands are typically used as a breakout indicator, it defines resistance and support levels and generate entries as price breaks these levels. As lows and highs usually correlate with support and resistance levels, this indicator is useful in objectively defining these areas.
Having said that, it’s also used as a reversal signal – entering when price touches a band and reverses its direction. Before utilizing the indicator in this manner, confirm the validity of the psychological level by demanding a minimum of 2 touches at the level. This ensures that the signal is solid and increases its dependability.
One other way of trading the Donchian Band is utilizing its middle band. The middle band is the average of the upper and lower band, and can also be used to quantify trend. Entry signals are generated in the following way: When price crosses the middle band from below – buy, and when price crosses from above – sell. It’s really a potent signal when trend strength is is verified with other indicators like the MACD and stochastic.
Investing Using Donchian Bands
There are numerous methods for deciphering and trading the Donchian Bands. Probably the most commonly used is definitely the breakout:
1. Long Trades – Long trades are entered when price breaks above the 20-period upper Donchian Band. Conservative traders wait for price to close above the Donchian upper band to enter the trade.
2. Short Trades – Short trades are entered when price breaks below the 20-period lower Donchian Band. Risk adverse traders wait for price to close below the Donchian lower band to get into the position.
Another approach to using Donchian Bands is using the middle band as the buy or sell signal line. Entry signals are produced in the following way: When price crosses the middle band from below – buy, and when price crosses from above – sell.
Donchian’s 20 Stock Trading Tutorials
Richard Donchian commenced his Wall Street livelihood in 1930. Donchian started out writing a technical market letter in 1933, and carried on for years. In 1934, Donchian created the subsequent 20 trading guidelines that are based in human psychology. Human psychology never changes thus these rules continue to be appropriate today.
1. Beware of acting right away on a popular public opinion. Even if correct, it will usually delay the move.
2. From a duration of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume increases.
3. Limit losses and ride profits, no matter all other rules.
4. Light commitments are recommended when market position is not certain. Clearly defined moves are signaled frequently enough and focus on these moves minimizes unprofitable whip-sawing.
5. Seldom take a position in the direction of an immediately preceding three-day move. Wait for a one-day reversal.
6. Judicious use of stop orders is a valuable aid to profitable trading. Stops are useful to protect profits, to limit losses, and from certain formations such as triangular foci to take positions. Stop orders are apt to be more valuable and less treacherous if used in proper relation to the chart formation.
7. In a market in which upswings are likely to equal or exceed down swings, heavier position needs to be taken for the upswings for percentage reasons – a decline from 50 to 25 will net only 50% profit, whereas an advance from 25 to 50 will net 100%
8. In choosing a position, price orders are allowable. In closing a position, use market orders.
9. Buy strong-acting, strong-background commodities and sell weak ones, subject to all other rules.
10. Moves in which rails lead or participate strongly are often more worth following than moves in which rails lag.
11. An analysis of the capitalization of a company, the degree of activity of an issue, and whether an issue is a sluggish truck horse or a spirited race horse is fully as critical as a study of statistical reports.
12. A move followed by a sideways range often precedes another move of just about equal extent in the same direction as the original move. Usually, when the second move from the sideways range has run its course, a counter move nearing the sideways range may be expected.
13. Reversal or resistance to a move will probably be encountered:
A. On hitting levels at which prior to now, the commodity has fluctuated for a considerable length of time within a narrow range
B. On approaching highs or lows
14. Watch for great buying or selling opportunities when trend lines are approached, especially on medium or dull volume. Be sure such a line has not been hugged or hit too much.
15. Watch out for crawling along or repeated bumping of minor or major trend lines and prepare to see such trend lines broken.
16. Breaking of minor trend lines counter to the major trend gives critical position taking signals. Positions can be taken or reversed at such places.
17. Triangles of ether slope may mean either accumulation or distribution contingent on other factors although triangles are frequently broken on the flat side.
18. Watch out for volume climax, in particular after a long move.
19. Do not rely on gaps being closed unless you can distinguish between breakaway gaps, normal gaps and exhaustion gaps.
20. During a move, take or increase positions in the direction of the move at the market the morning following any one-day reversal, however slight the reversal may be, particularly if volume declines on the reversal.