What it means
Imagine plotting a share's highest price over the last 20 days and its lowest price over the same days. Draw one line along the highs and one along the lows, and the price sits inside a channel.
When the price pushes through the top of that channel, it has reached a new 20-day high, which many traders treat as a sign that an uptrend may be starting. The upper line is the highest high of the chosen period, the lower line is the lowest low, and the middle line is their average.
Because the channel is based only on actual highs and lows, it widens in volatile markets and narrows in quiet ones. A narrow channel often means the market is coiling, while a wide one shows large swings.
Richard Donchian is often called the father of trend following, a style of trading that tries to ride sustained price moves instead of predicting turns. His breakout approach later became well known through the so-called Turtle traders of the 1980s, who used entry and exit rules based on 20-day and 55-day highs and lows.
The story is a popular case study in rule-based trading. A typical rule is to buy when the price closes above the upper line and sell, or go short, when it closes below the lower line.
Exits can use a shorter channel, such as a 10-day low for a long position. Using clear rules removes much of the emotion from trading decisions.
The tool has weaknesses. In sideways markets, prices poke above and below the channel often, producing false breakouts and repeated small losses.
Trend followers accept that many trades will lose a little, hoping that a few big trends make up for them. Business readers rarely trade on these lines directly, but the idea is useful in other settings.
Treasury teams, commodity buyers and analysts sometimes use a high-low range over recent months to judge whether a price is unusually high or low. Knowing the vocabulary helps in conversations with traders and advisers.
In practice
Real-world examples.
Example
A commodity trader watches the price of copper using a 20-day channel. When copper closes above the upper line for the first time in a month, she buys a small position and sets a stop below the middle line.
Example
A currency analyst finds that a pair has traded in a narrow channel for six weeks. He expects a larger move soon and prepares to trade whichever way the price breaks out, with a small position to limit losses.
Example
A procurement manager at a food company tracks the 60-day high and low of wheat prices. When prices approach the lower line, he asks the purchasing team to buy extra supply for the next quarter.
Formula
Calculation
Upper line = highest high over the last N periods
Lower line = lowest low over the last N periods
Middle line = (upper line + lower line) / 2
Worked example: Using a 20-day setting, a share's highest price in the last 20 days was $58 and its lowest price was $50.
Upper line = $58.
Lower line = $50.
Middle line = ($58 + $50) / 2 = $108 / 2 = $54.
Channel width = $58 - $50 = $8.
If the share closes at $59 tomorrow, it has closed above the upper line, which a breakout trader would treat as a buy signal. A fall to $49 would be a close below the lower line, a sell or short signal.Case study
Seen in the real world.
Ironbridge Capital is a fictional small fund that adopted a Donchian breakout system on twelve commodity markets. The rules were simple: buy a new 55-day high, sell a new 55-day low, and exit on a 20-day reversal.
In this illustrative case, the first six months produced many small losses as markets moved sideways. Some partners wanted to abandon the system, but the risk manager pointed out that the losses were within the limits set at the start.
In the seventh month, a long trend in energy prices produced a gain that more than recovered the earlier losses. The fund kept the rules, kept position sizes small and reviewed results annually. The illustrative lesson is that a trend system needs patience and strict risk limits.
Watch out
Common mistakes.
- Expecting every breakout to continue. Many breakouts fail, and the tool works because winning trades are larger than losing ones, not because most trades win.
- Using the same setting for all markets. A period that suits a volatile commodity may be too short or too long for a slow-moving asset.
- Ignoring risk controls. Without stop-losses and sensible position sizes, a run of false breakouts can cause serious damage.
Questions
People also ask.
Who created Donchian Channels?
They are named after Richard Donchian, who developed rule-based trend-following methods in the twentieth century.
What is the most common setting?
Traders often use 20 periods, but others use 10, 55 or more depending on how quickly they want to react.
How do they differ from Bollinger Bands?
Donchian Channels use the highest and lowest prices, while Bollinger Bands are based on a moving average and standard deviation.
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