Option Investor
Trader's Corner

Easy, Breezy Identification of Historical Support and Resistance Using Donchian Channels

HAVING TROUBLE PRINTING?
Printer friendly version

A 1970 booklet introduced one of the trader's best and easiest tools for identifying historical support and resistance: the Donchian channel. As originally developed, a Donchian channel sets the top boundary at the highest high for four weeks and the lower boundary at the lowest low for four weeks.

Note: Charts were prepared in advance, so do not reflect current values.)

Annotated Daily Chart of the OEX:

The 20-period default setting refers back to that four-week period that Richard Donchian used when developing his trading system, but most charting services that include Donchian channels also allow default settings to be changed. What could be easier than snapping a Donchian channel on a chart of any time period to identify historical support and resistance?

Knowing the location of historical support or resistance provides obvious benefits. Such support and resistance levels can corroborate support or resistance established by other means, such as pivot points, nested Keltner channels, regression channels, Bollinger bands, trendlines and formations.

Annotated Three-Minute Chart of the ES Contract:

Richard Donchian advocated using these support and resistance levels in a particular and simpler manner, however. He believed in an always-in-the-market system, and used the Donchian channels to determine the correct time to switch sides. He covered short positions and entered long ones when prices exceeded the top channel and liquidated long positions and entered short ones when prices violated the lower channel. Some studies conclude that trading systems that consistently pinpoint and act on breakouts prove the most profitable over the long run, and Donchian's system has been labeled the simplest of such systems.

A glance at the previous two charts displays a curious effect, however. Prices aren't closing above the channels. By the end of a period that nudged a Donchian channel either higher or lower, prices had closed back inside the channel. To help identify breakouts, some offset the channels, with many charting services allowing for such an offsetting.

Annotated Three-Minute Chart of the ES Contract:

Although the trade was profitable, it obviously did not capture the entire price run in this instance. When studying Donchian channels in 2003, I experimented with using a smaller Donchian channel to refine entries and exits, a tactic that turned out to be a recommended one.

Annotated Three-Minute Chart of the ES Contract:

This trade would have proved more profitable, but a further examination of the chart reveals that the trader using this system would have been whipsawed out of a couple of trades afterwards. My study of Donchian channels in 2003 indicated that the number of whipsawed trades proved to be one shortcoming of the system. Profitable overall, the ratio of profitable to unprofitable trades, the number of losing trades in a row and the drawdowns would have proven unpalatable for most traders. The system always identified the big moves early, but all trades had to be taken in order to catch those big moves. Those with deep pocketbooks, lots of patience and an unerring faith in the system despite an almost 50/50 win/loss rate could have profited from this system, but that combination of parameters doesn't describe most traders.

However, that fact doesn't change the usefulness of Donchian channels as an adjunct to other trading tools. The easy identification of historical support and resistance rates and early identification of breakouts make this a valuable tool for traders whose other charting methods have suggested an imminent strong move.
 

Trader's Corner Archives