Donchian Channels (DC)
Definition
Donchian Channels (DC) are used in technical analysis to measure a market's volatility. It is a banded indicator, similar to Bollinger Bands %B (%B). Besides measuring a market's volatility, Donchian Channels are primarily used to identify potential breakouts or overbought/oversold conditions when price reaches either the Upper or Lower Band. These instances would indicate possible trading signals.
History
The Donchian Channels (DC) indicator was created by the famous commodities trader Richard Donchian. Donchian would become known as The Father of Trend Following.
Calculation
For this example, a 20 day period is used which is a very commonly used timeframe.
Upper Channel = 20 Day High
Lower Channel = 20 Day Low
Middle Channel = (20 Day High + 20 Day Low)/2The basics
Donchian Channels are one of the more straightforward indicators to calculate and understand. The indicator simply takes a user defined number of periods (20 Days for example) and calculates the Upper and Lower Bands. The Upper Band is the high price for the period. The Lower Band is the low price for the period. The Middle Line is simply the average of the two.
The main function of Donchian Channels is to measure volatility. When volatility is high, the bands will widen and when volatility is low, the bands become more narrow. When price reaches or breaks through one of the bands, this indicate an overbought or oversold condition. This can essentially result in one of two things. First, the current trend has been confirmed and the breakthrough will cause a significant move in price in the same direction. The second result is that the trend has already been confirmed and the breakthrough indicates a possible small reversal before continuing in the same direction.
What to look for
Trend Confirmation
Oftentimes, in a clearly defined trend, overbought or oversold conditions can be a significant sign of strength.
During a Bullish Trend price moving into overbought territory can indicate a strengthening trend.
During a Bearish Trend price moving into oversold territory can indicate a strengthening trend.
Overbought/Oversold
During a Bullish Trend, price may move into short-term oversold conditions. These oversold conditions can also indicate a strengthening trend.
During a Bearish Trend, price may move into short-term overbought conditions. These overbought conditions can also indicate a strengthening trend.
Summary
The Donchian Channels indicator (DC) measures volatility in order to gauge whether a market is overbought or oversold. What is important to remember is that Donchian Channels primarily work best within a clearly defined trend. During a Bullish Trend, movement into overbought territory may indicate a strengthening trend (especially if the movements occur frequently during the trend). During a Bearish Trend, frequent movement into oversold territory may also indicate a strengthening trend. Also, during an uptrend (downtrend), movements into oversold (overbought) territory may just be temporary and the overall trend will continue. That being said, being sure of the overall trend plays a major role in getting the most out of Donchian Channels. They could be used with additional technical analysis tools such as trend lines or the Directional Movement (DMI) indicator.
Inputs
Length
The time period to be used in calculating the Donchian Channels (20 is the Default).
Offset
Changing this number will move the Donchian Channels either Forwards or Backwards relative to the current market. 0 is the default.
Specifies
Timeframe
Specifies the timeframe that the indicator is calculated on. This option allows calculating VWAP based on a data from another timeframe, e.g. having VWAP calculated on 1H chart be displayed on a 5m chart.
Wait for timeframe closes
Specifies the behavior when the indicator's timeframe is higher than the chart's. When 'Wait for timeframe closes' is checked, higher timeframe values only come in and are interconnected on the chart when the higher timeframe completes.
Style
Basis
Can toggle the visibility of the Basis as well as the visibility of a price line showing the actual current price of the Basis. Can also select the Basis' color, line thickness and line style.
Upper
Can toggle the visibility of the Upper Band as well as the visibility of a price line showing the actual current price of the Upper Band. Can also select the Upper Band's color, line thickness and line style.
Lower
Can toggle the visibility of the Lower Band as well as the visibility of a price line showing the actual current price of the Lower Band. Can also select the Lower Band's color, line thickness and line style.
Background
Toggles the visibility of a Background color within the Bands. Can also change the Color itself as well as the opacity.