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Donchian Trading – What Do We Know?

Trading has gained immense popularity in countries all over the world and this is solely because of the high success rates enjoyed by many stock traders.

Trading is more than just the understanding of derivative markets but also an attempt to learn the ever-changing movements of the stocks.

Several tools like Technical Indicators contribute to the knowledge of the traders. Technical Indicators are the often represented by squiggly lines found above, below or on-top-of the price information on a technical chart.

Donchian Trading Guidelines are one of the first books in trading which provide guidelines for traders around the world as to how one must tackle the stock market changes. It has been authored by Richard Donchian and was first published in the year 1934.

He talks about several terminologies in trading that we deal with today in his book. One of them is that of “channels” or now known as Donchian Channels.

What are Donchian Channels?

A channel line is the amalgamation of two parallel trend lines that act as areas of support and resistance.

It is an indicator used in the market to find the volatility of a market price.

It is created by taking the highest high and the lowest low of the last n periods. The area between the high and the low is the Donchian channel for the period one chooses.

Donchian Trading Guidelines

Donchian guidelines for trading have been divided into two parts – General and Technical.

According to the first part of the Donchian Trading, the General guidelines one must follow are:

  • Always trade in smaller amounts during times of uncertainty. Trading losses can be reduced by focusing on absolutely sure signals.
  • One must understand the meaning of the words: “UPTREND” and “DOWNTREND” when it comes to trading.

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When a stock shows strength in terms of its movements, its movement can often be referred to as an “Uptrend” or an ascent in its movement.

Likewise, when a stock shows signs of weakness in its movement, its movement can be referred to as a “Downtrend” or a descent in movement.

It is always advisable to buy securities that are in ‘uptrend’ and show signs of strength. At the same time, it is advisable to sell securities that are in ‘downtrend’ and show signs of weakness.

  • Learning about the different terminologies associated with the trade graph is another important factor.

One must know the structure of a stop-loss, which must be used to restrain losses and protect acquired profits.

Stop-losses should be based on the trading pattern at work, i.e., it is important to note that a triangular pattern will have a different stop-loss structure than a rising wedge pattern or head-and-shoulders pattern. Therefore, it is absolutely necessary to read the trading pattern carefully.

  • Even when a crowd of traders are proven right, excessive sentiments towards one direction or another can delay a movement in price.
  • When prices of shares trend in the narrow range and show signs of irreverence, it would be advisable to look for an increase in volume that would in turn help in predicting the next best move.
  • To understand “volume” while dealing with shares, one must learn to distinguish between the terms “bullish” and “bearish” – terms that are often used during trading.

Prices that show consecutive signs of strength on higher volume are considered to be bullish, whereas prices that show consecutive signs of weakness on higher volume are considered to be bearish.

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Thus meaning, when you notice that you are running the risk of losing more money than you must, always cut the share loose. You’re here to win!

  • Traders always believe that one must not chase a position of the derivatives after a three day move. Always wait for a one day reversal to enhance the risk reward ratio.
  • One must know what is the different between “Market Order” and “Limit Order”.

Market Order will pursue your order at the given current market price, while Limit Order is a conditional order and it will be executed at the price specified by you or at a price profitable to you.

Thus, one must use limit orders while starting off on a position and use market orders when closing a position.

Donchian Trading Guidelines grow slightly ambiguous when it comes to the point about “Capitalization”.

Donchian states that a security’s capitalization along with its activity level in the marketplace and its trading characteristics are just as important as its fundamentals.

Thus, this guideline solely depends upon your own perspective of stock capitalization.

According to the second part of Donchian Trading, there are technical rules one must follow in trading and they are:-

  • A sideways trading range after an initial advance is often believed to lead to another advance of equal proportions. After its second advance, trade chartists can expect a reversal and descent towards the consolidation.

Similarly, a consolidation or sideways trading range after its first descent often leads to another decline of equal proportions.

  • A long sideways concentration after an advance shows signs of future resistance. In such cases, it would be advisable to expect resistance or a bearish reversal when prices go down and return to the previous level.

A long sideways concentration after a descent shows relative support in the future and in such cases it would be advisable to expect support or a bullish reversal as the prices go up and then return to this level.

  • Always buy commodities that have a strong background and are showing signs of strength and follow the moving averages provide objective behind buying and selling signals.

Thus, buy shares when prices decline to a trend line on an average or low volume and sell them when prices go up to a trend line.

  • One must remember that major trend lines show the longer trend while minor trend lines show the shorter trend.
  • While reading a trade chart, if one notices that triangles on the chart are usually broken on the flat side, it is an indication that an ascending triangle is usually broken marking an upside breakout, while a descending one is usually broken to the downside.

In such cases, trade chartists must look for other hints to determine if a triangle signals accumulation or distribution.

  • Always look for a volume pitch that could signal the end of a long move. An extended move could indicate a volume surge which would end in a fizzle while an extended descent could indicate a volume surge creating a selling pitch.
  • Understanding functions of gaps is very important. Breakaway gaps could mark the beginning of a new trend and are illustrated by gaps that are not filled.

Continuation gaps could mark a continuation of the existing trend while exhaustion gaps mark a trend reversal and are illustrated through gaps that are filled.

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  • It is important to remember that during an advance in stock movement, begin or add to long positions after a one day decline, more so when the decline is on lower volume.

During a decline, begin or add to shorter positions after a one-day advance, more so if the bounce is on lower volume.

Donchian Trading is often considered to be the father of the trading approach “Trend Following”.

It is based on the assumption that commodity prices moved in long, sustained moves.  In spite of the theory having developed years and years ago, it is still just as relevant in today’s trading world.

Therefore, it would be advisable to begin your journey as a trader with a clear understanding of Donchian Trading Techniques as most of what we know about trading techniques today stem from these – especially trading approaches like Technical Analysis have their origin within the theory of Donchian Trading.

If there are any more details you wish to discuss with us regarding Donchian Trading, please leave a comment!