Donchian channels explained simply

Richard Donchian is considered one of the fathers of trend following. In the 1950s and 1960s he used simple rules: buy when the price makes a new high over a certain period. The channels became famous through the Turtle Traders, a group of beginners trained with exactly such rules in the 1980s.

What it's about

The upper line shows the highest high of the last 20 days, the lower line the lowest low. The channel lies in between. It uses no average and no formula, only the outermost prices.

An example: a stock has been swinging between €58 and €63 for a month. Today it rises to €64. It breaks out above the upper line and is higher than at any point in 20 days.

How it's calculated

The upper line is the highest daily high of the last 20 days. The lower line is the lowest daily low. Some also draw the middle, the average of the two.

With numbers: over the last 20 days the highest high was €63 and the lowest low €58. The middle is at €60.50.

What signals traders read from it

• Upside breakout: A close above the 20 day high counts as a buy signal for trend followers.
• Exit: Many exit when the price drops below the low of a shorter period, such as the last 10 days.
• Channel width: A narrow channel shows a calm phase, a wide one a restless one.

Where it misleads you

Most breakouts fail. Trend following with Donchian channels depends on a few big trends more than making up for the many small losses. That also means you often lose several times in a row, sometimes ten times or more. If you can't stand that, you quit right before the big trend.

Also, many traders have used this simple rule for decades. In some markets it has lost much of its effect.

An example trade with made up numbers

Karl has €10,000 in his account and risks at most €150 per trade. A stock rises above its 20 day high of €63, and the 10 day low is at €60. Karl buys at €64 and sets his stop loss at €60. With that distance, he buys 37 shares for €2,368. Costs: €1 each to buy and sell, plus about 2 cents of spread per share on each order.

If it works: The trend carries the price to €76, then it drops below the 10 day low and Karl sells at €72. Karl is €296 ahead. After €2 in fees and €1.50 in spread, €292.50 is left.

If it goes wrong: The breakout fails and the price falls back into the channel. The stop fills at €59.90. That's a €151.70 loss, €155.20 with costs.

Karl knows such breakouts fail more often than they succeed. He still risks the same amount every time, so one big trend can make up for the series of small losses.