Trading 101: Using Donchian Channels To Predict Market Volatility

2021/09/02 10:45:44

Technical analysis is without a doubt the most popular and effective method for analyzing prices and forecasting future market movements. Technical analysis may be done in various methods, but the indicator-based analysis is one of the most common.

Technical indicators are used to assess market conditions by filtering out the noise (volatility). And others that assist in comprehending the trend and the momentum that surrounds it. However, there is a select handful that provides information on volatility, trend, and momentum. One such flexible indicator is the Donchian Channel indicator that extensively deals with the volatility of the market.

What is the Donchian Channel Indicator?

The Donchian Channel is a volatility indicator that uses the highs and lows of a specific timeframe to indicate support and resistance levels in the market. The indication is shown with the price action, which seems to be moving in a channel.

Donchian Channels are most commonly used on candlestick charts rather than line charts since candlesticks take into account the high, low, open, and close that the indicator requires in its computation. As a result, it clearly aids analysts in comprehending the underlying asset's volatility.

Traders utilize the channel drawn around the price movement to spot possible breakouts and retracements. It establishes the link between an asset's previous price and present price, allowing speculators to forecast bullishness and bearishness in a certain timeframe.

Working of Donchian Channel Indicator

The Donchian indicator is a price movement channel with three lines drawn against it. The key to understanding the indication is to understand the three bands: upper, lower, and middle.

The market's momentum is signified with all three bands working together. The top band indicates the preceding period's highest high, while the lower band reflects the previous period's lowest low. The middle band is calculated by taking the average of the current high and low for that trading session.

Applying Donchian Channels Indicator on the Bitcoin Price Chart | Source: BTC/USDT

Comprehending the Donchian Channel Bands

Upper Band

If the market is trading between the middle and upper bands and mostly lingering near the upper band, it suggests that buyers are in control of the market, and the same trend could continue in future trading sessions. As a result, traders position themselves in search of purchasing opportunities.

Lower Band

When the market trades for an extended length of time towards the lower band, it indicates that the bears are attempting to keep charge in the market. As a consequence, analysts prepare to sell short in such markets.

Middle Band

As previously stated, the center band is the average of the upper and lower bands for that period. Suppose the price action is just about in the middle band. In that case, it suggests that the underlying asset's volatility is low, and there is no obvious indication of whether the bulls or bears will lead the market in the future.

How to trade using the Donchian Channel Indicator?

The Donchian channel specifically determines the side at which there is excess volatility in the market. But simply selling the lower band or buying at the upper band is not an effective method to trade in the market. The indicator depicts its real value only when combined with other technical factors.

Strategy 1 - Donchian Channel with Supply and Demand

Going by the definition, supply is a level where the market tends to drop, and demand is a level where the price begins to rise. The strategy is based on the same conceptual idea.

According to the strategy, one can buy at the demand zone after the price crosses above the middle band from the lower band. Similarly, traders can go short from the supply level as the prices cross below the middle band from the upper band.

In the below example, it is observed that the entire market is in an uptrend. The most demand is formed at $44,000. The market begins to retrace after setting a high at $48,000. As the price approaches the demand level, one must closely watch the price action and the band at which it is trading. Once the market that was trading at the lower band breaches above the middle band, one can prepare to go long.

Donchian Channels Buy Example on the Bitcoin Price Chart | Source: BTC/USDT

Strategy 2 - Donchian Channel Range Breakout Strategy

A range is a sequence of equal highs and equal lows. Visually, the market moves in a sideways direction. A range breakout strategy is a popular technique to trade breakouts in the market. Typically, after a market breaks out of a Support/Resistance level, the price continues to move in the direction of the breakout.

The Donchian Channel Range Breakout strategy leverages the fact that the volatility on the sell-side increases as the market trades around the lower band of the channel. According to the strategy, one can sell short when the price breaches below the Support level of a range after confirming that the price action is below the middle band.

In the self-explanatory example below, traders can execute their sell orders as the prices plunge below the bottom of the range after ensuring that the price is hovering between the lower and middle bands.

Donchian Channels Sell Example on the Bitcoin Price Chart | Source: BTC/USDT

To summarize, the Donchian Channels are a powerful technical indicator that helps identify not just market volatility but also the market's future trend. It is an excellent indicator in itself but should always be combined with other technical variables such as indicators or any candlestick patterns to improve the accuracy and dependability of the signals generated.

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