Donchian Channels are a technical analysis indicator used for visualizing the volatility in the marketplace. The indicator consists of three bands: an upper, lower, and middle, median band. The upper band shows the highest price over a select period of time, while the lowest band shows the lowest price. The middle band shows the median of the lower and upper bands.
The main use of the bands are to show a security’s lowest and highest points to trade events such as reversals and breakouts.
How to trade the Donchian Channels
Similar in function to Bollinger Bands, Donchian Channels can help you spot oversold and overbought territories and also helps with mean reversion techniques. For example, if price is consistently trading above the mean this could indicate an overbought market, while a significant time trading below the mean could indicate an oversold market.
The final way to use Donchian Channels is by anticipating a reversion to the mean, which is a common occurrence in trading and statistics. When prices consistently trade above or below its mean, in all likelihood prices will revert back to the middle line; this can be useful information for forecasting trade entry points.
Comparing Donchian Channels with Bollinger Bands
Donchian Channels and Bollinger Bands share some common characteristics, but their calculations and interpretation are different from each other. Bollinger Bands work as standard deviations from price and uses an exponential moving average in place of Donchian Channel’s mean.
The use of standard deviations means that prices can break above and below the Bollinger Bands, which can infer strong bullish or bearish activity. On the other hand, Donchian Channels will always encompass price action as the channels are formed based on the highs and lows.
Both can be overlaid on the same chart if you’d like to have the best of both worlds.