Channels are among the most appreciated tools in technical analysis, as they visually convey to the trader the boundaries within which most price movements tend to occur.
Those who use channels know that valuable information can be obtained at any moment, whether prices are in the central region of a band or near one of the boundary lines.
Thus, given the relevance of channels for operations based on technical analysis, the Donchian Channel was developed.
To add the indicator to your chart, go to the Indicators menu under View and search for Donchian Channel:
Concept
The Donchian Channel is a trend-following indicator based on volatility, formed by three elements:
- Lower Band: Defined by the lowest price over the last N periods.
- Upper Band: Defined by the highest price over the last N periods.
- Central Line: Not a moving average as in other techniques, but rather the midpoint between the lower and upper bands.
By analyzing the components of this method, we can identify some interesting characteristics. The main one is that there are no averages in the calculation, so the bands tend to react quickly to market changes.
When working with averages, even weighted or exponential ones, the impact of each data point is somewhat smoothed out. With the Donchian Channel, an aggressive price movement will trigger an equally aggressive reaction from the indicator.
Using the Donchian Channel
The essence of applying this method lies in the fact that a breakout of the upper or lower band represents a significant (and often strong) move toward new highs or lows.
In other words, in addition to monitoring volatility and following trends, the use of this indicator relies on the idea of breakouts to build trading strategies.
The main rules of use can be described as follows:
- When prices close above the upper band, it generates a buy signal.
- When prices close below the lower band, it generates a sell signal.
These events are seen as indications of trend continuation and even acceleration. Note that the technique describes market entry signals, while exit and risk management should rely on other analytical tools.
As mentioned, the Donchian Channel is a trend-following indicator, meaning reduced performance is expected during periods of sideways or consolidating markets.
The time parameter of the indicator determines how many previous periods it will monitor, with 20 being the typical number. However, many traders use smaller values to achieve an even faster reaction to price action, especially for day trading.
It is also important to remember that the usage rules were designed with market entry in mind, whether for buying or selling. For exits, as well as stop placement and risk management, complementary techniques should be used.
Using the Offset
It is important to mention that the breakout, as described above, only occurs with the use of an offset.
By default, the indicator is plotted with an offset of 0, causing the bands to closely follow the candles.
Below is an example of how the indicator is presented with an offset of 1:
To configure the Offset, right-click on the indicator and go to Properties. It is possibile to modify the Offset in the Properties tab.
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