The Donchian Channel indicator helps traders to identify bearish and bullish extremes with potential breakouts, reversals, breakdowns, or emerging trends. What’s more, it seeks the price highs and lows. Developed by Richard Donchian and at the beginning of the 80s, the indicator consists of several baseline elements that traders need to know in order to use the tool properly under real market conditions.
In this article, we will learn how the Richard Donchian indicator works and how it differs from Bollinger Bands. What’s more, you will find a secret pro tip with the most common mistake to avoid when using this instrument. Let’s get it started.
As stated earlier, the indicator was developed by Richard Donchian. It was first introduced more than 20 years ago. However, it is still pretty popular with traders and investors of all levels. On the one hand, it can be pretty complicated for beginners right at once. On the other hand, it takes little time to clarify how the tool works and how to use it.
First of all, we will introduce the three major elements the indicator consists of. They are actually the three lines plotted by the moving average calculations:
The middle band is the area where the indicator is formed.
The main aim of using the Donchian Channel indicator is to see the relations between the trading range and the current price over a given timeframe. It utilizes three major values we have discussed earlier to form a visual price map (the same way as Bollinger Bands. However, the two indicators are different).
As a result, traders are able to see the extent of bearishness or bullishness for a given timeframe. To identify the bullish energy, traders use the top line and vice versa – the bottom line helps to identify the bearish activity.
Some beginners do not know how to use the indicator right at once and start trading it blindly when using the bands. Some of them think that the price upper band shows that overbought market condition with a chance to make a reversal at a lower level. As a result, they go short.
That is wrong! In reality, when being in the uptrend, the price can hug the higher band for a longer period instead of making a reversal. In other words, the indicator DOES NOT work in case you need to identify the oversold or overbought market.
Bollinger Bands mainly consider the market volatility and adjust its values accordingly. On the other hand, Donchian Channel indicators come as a fixed value based on the timeframe highs and lows.
What we have learned from today’s article is that Donchian Channel refers to the category of trend-following indicators. It consists of three major bands that help to define bearish and bullish energy. However, it may come with certain limitations and false signals traders may interpret wrongly.
Whatever you do, never use the indicator to identify market overbought and oversold conditions. A good idea is to combine the tool with some other technical indicators such as ATR, for example. The combination will make it possible to catch explosive breakouts and price reversals other traders cannot see. Don’t forget about risk management tools and use a trailing stop loss.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.