The Danger of Donchian Channels – Never Swim Alone

Posted on by The INO.com Team

Over the past few weeks I’ve shown you video examples of how you can use three powerful, yet straightforward indicators – the Donchian Channel, Williams %R, and MarketClub’s Trade Triangles – in combination to quickly find and grab some not-too-shabby profits in sideways markets.

Today I’d like to take a closer look at one of them – the Donchian Channel – and how misusing it could sink your trading portfolio.

If you’re new to trading, today’s post is a must read.
As I mentioned in the earlier oil video example, the Donchian Channel is a trend tool.  To be more specific, it is a moving average indicator that plots the highest high and lowest low over the selected time intervals – which are displayed as upper and lower channel lines on your chart.

This means three very important things:

First and foremost – when the price breaks above or below the Donchian it does NOT signal a reversal. This is where someone who is new to trading and unfamiliar with Donchian Channels can easily find themselves in trouble if they’re not careful.  When someone looks at a chart and sees an indicator line cross over another line or, as in this case, move outside of a range or set of boundaries, they are natural inclined to think it means a change in price direction...

However, with the Donchian Channel the opposite is true – a breakout actually signals that a new trend may be establishing itself:

A price breakout on the high side of the channel, it can indicate the start of a new upward trend – signaling to traders to go long and cover shorts.

A price breakout out on the low side it can indicate the start of a new downward trend – signaling to traders to sell short and liquidate long positions

Of course, there is just one small problem – the Donchian Channel indicator isn’t always right.  NO indicator is.  And that, as any experienced, successful trader knows, is why basing your trading decisions on just one indicator alone is a surefire way to reach a $0 account balance in your trading portfolio in no time flat.

Again, our earlier oil video is a perfect example of this...

If you had acted on the Donchian Channel breakouts alone, you would’ve been on the wrong side of the move every time.

If you had acted on the Williams %R indicator alone, your timing would have been off and you would’ve missed out on a significant amount of profit.

And, if you had acted on the Trade Triangles alone, you would have wasted time and trading fees on smaller, inconsequential trend shifts (whipsaws) that occurred between the true, money-making moves.

Combine all three though and now you’re cooking! You would have caught – and profited from – two explosive moves (and a potential third one) in 8 weeks without being caught up in any little whipsaws.
With just a little know how and the right tools you can open up a whole new world of profits and trading success.

All the best to you,
Adam Hewison
President of INO.com
Co-founder of MarketClub

20 thoughts on “The Danger of Donchian Channels – Never Swim Alone”

  1. I know next to nothing about about trading. How do I become familiar with what I need to know to use your services?

    1. Lewis,

      My recommendation would be to educate yourself and how markets really work. To do this I would suggest that you take a 30 day risk free trial to MarketClub itself. Here you'll find lot's of educational information that has been broken down so you can quickly learn to trade.

      Is the link that you need to get started.
      https://secure.ino.com/products/marketclub/

      All the best,
      Adam

  2. Thank you Adam.

    Adam, please take a look at my two suggestions below.

    This blog post was useful, and might help me improve my trading. By the way, the Williams %R and Donchian Channel are almost the same thing, although plotted differently. One can see this from their formulae (definitions). Informally explained: Williams %R is the relative position of todays price between the extreme low and extreme high of some number of days back in time. Donchian Channel, is constructed by plotting the extreme low and extreme high of some number of days back in time.

    I have also notiched that the daily trade triangles usually coincide with breakouts in Donchian Channel with n = 3 days. (I guess that's old news).

    It was nice that you acknowledged the problem ow whipsawing when using only trade triangles. I am still searching for a way out of that, and maybe the technique you described can help me.

    Suggestion 1:
    Now, there is something that I would appreciate very very much. Could you put the time and price of the trade triangles into a downloadable table? I know that you and Market Club recognize the need for your members to do offline analysis (backtesting) of historical data. And it is cumbersome to read one by one triangle value out of the graph and type them by hand into a spreadsheet. So please place the data in tables. That would be great. Thanks in advance.

    Suggestion 2:
    Here is one more suggestion. A horizontal scroll bar or the graph or a "hand" mouse pointer (like in Adobe Acrobat and many other places) to move the plot sideways would be great.

    1. Gunnar,

      Suggestion 1:
      Now, there is something that I would appreciate very very much. Could you put the time and price of the trade triangles into a downloadable table? I know that you and Market Club recognize the need for your members to do offline analysis (backtesting) of historical data. And it is cumbersome to read one by one triangle value out of the graph and type them by hand into a spreadsheet. So please place the data in tables. That would be great. Thanks in advance.

      On the drawing board.

      Suggestion 2:
      Here is one more suggestion. A horizontal scroll bar or the graph or a “hand” mouse pointer (like in Adobe Acrobat and many other places) to move the plot sideways would be great.

      Good idea. I have passed your ideas along to our IT department.

      Thanks,
      Adam

  3. Thanks for the informative video. I found a stock today (TSE:MOL)that is in exactly the position shown in the video example, so I am giving it a try to see if this is works as well as it did in the video today. Got my fingers crossed!

    1. Robert,

      Some people use the Donchian channels this way. If the trend is moving higher then they would indicate that when the price action moves outside of the lower channel that would be a reversal or could be used as a stop.

      That is the only way that I know how people use Donchian channels. Dick Donchian developed the system in the 1940s and sure this more information online about him.

      All the best,
      Adam

  5. Adam,
    I have a question on going short, given the approximate "USO 12/8 date" with a Red daily triangle signal. You indicated not to short because candles will stay within the Donchian Channels boundries (sideways). So what would have keep someone from going short at this red triangle? I see no look forward information not short and don't know that future candles will stay within the Donchian Channels boundries?

    Thanks, Robert

    1. Robert,

      It is possible you could have gone short the USO on 12/8. However you would been stopped out when you had a green daily triangle on 12/13 for a small loss of $.61 a share.

      I hope this answers your question.

      All the best,
      Adam

  6. Trade triangles are based on Donchian Channels. The Turtles made a lot of $$$ this way. They also incorporated a unique position sizing. The entire system is available online.

  7. Hi All I have been using the 'DC' for some time on my charts I mainly use it for my indication where to put my stop loss when I get a signal to buy or sell with the MACD confirming the direction of the move. It is great to know that you are showing other and myself using the 'DC'. Thank for the Williams %R I now add this as part of my tools.

    Raymond

  8. >And, if you had acted on the Trade Triangles alone, you would have wasted time and trading fees on smaller, >inconsequential trend shifts (whipsaws) that occurred between the true, money-making moves.

    Adam, thanks for this blog entry. You'll recall I asked about using the Donchian channels and R2 with weekly trade triangles (TT) and the periods required. Your point on "whipsaws" on the TTs is well made -- even on the weeklies on some tickers. This was particularly true in the market last year in Summer and Fall. I really try to avoid unnecessary trades, particularly when it's easy to be on the losing side of the trade (notwithstanding that red weeklies do, at least, protect the position to a large extent). And of course, it is easy to be wise after the event, or as Elder puts it, "..in the middle of the chart".

    I have found that using MACD trends, crosses and ultimate values can help avoid whipsawing on weekly TTs. For example, if MACD line is positive I am disinclined to sell on a red weekly TT, negative disinclined to buy on a green. I do pay attention to the crossovers and some other indicators but I have found using MACD in conjunction with the weekly TTs to be a good additional guide (SPY from May-sept 2010 is a good example)

  9. If the Donchian channels don't signal a reversal, why do all your Daily Triangles indicate a reversal in position on the Crude Oil chart you showed in the video?

    -Bill

    1. Bill,

      Thank you for your feedback.

      The video you're referring to is now 10 days old and the system that we were explaining is a short term system. Things have changed since that video was made and that's why it's important to understand how the markets really work.

      I hope this answers your question.

      All the best,
      Adam

  10. Thank you Adam for the explanation, I'm not a beginner, but thanks for the refresher. It's always good not to forget the basics.

    Now would it be possible for you to give an example using a "regular" stock, like AAPL, or any other one.
    I want to make sure this "3-tool technique" works on ANY stock!

    Peter

  11. Great video on Donchian Channels. My questions is does this same technique work for equities with the weekly triangle?

    1. Vicky,

      Thank you for your feedback and your compliments I appreciate it.

      To answer your question does the same technique work with equities with weekly triangles. It is possible, but I cannot say for certainty as I've not spent a great deal of time looking at that part of the equation.

      If you do some exploratory work on that thesis I would appreciate hearing back from you.

      All the best,
      Adam

    1. Siang,

      The short answer is yes. But like a lot of trading systems and techniques, it doesn't work all the time. You must be aware of that if you going employ this strategy.

      Every success and good luck with your trading.

      Adam

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