Contents:Many trading strategies in binary options are based on following the trend as this is the way to maximize potential profit from strong movements. Donchian Channel is a technical indicator developed by futures trader - Richard Donchian - also known as The father of trend following. Although the indicator was initially developed to trader futures contracts, it gained popularity in trading binary options and Contracts For Difference (CFD) thanks to the simple mathematical formula, easy applications on price charts and reliable trading signals.
Donchian Channel belong to the envelope family of technical indicators. The most widely-used envelope indicators are Bollinger Bands and Keltner channels. The main idea is that asset prices usually move in so-called channels, shifting the lower and upper band in accordance with the trends direction. Sometimes markets get into a consolidation stage with a sideways directionless action. Envelope indicators point to trends direction, show possible resistance and support levels and signal possible reversals. This article is aimed to explain the details of using Donchian Channel in binary options trading, highlight strengths and weaknesses of the indicator and show several examples of profitable trading decisions.
What is a Donchian Channel?
Donchian Channel is an on-chart indicator with three lines pointing to the upper, lower and middle ranges of the recent price change in the given number of periods. The technical tool is used to find reversals, indicated breakthroughs and rebounds and underline emerging trends. One of the most powerful applications of the indicator is a mean-reversion trading approach when binary options traders follow trends and buy options according to the main direction after counter-trend retracements are over. Donchian Channel are used with any asset class on any timeframe, which makes the trading strategy flexible and universal.
Here is how the indicator looks like on a price chart:
Donchian Channel Indicator simply picks the highest rate within the chosen period for the upper line and lowest price for the lower band, so breakthroughs of those lines by the price are impossible. The middle line is calculated by simply averaging those two values (high and low), and it Is moving together with the price action. Periods when the extreme borders of the indicator spread show higher volatility, while the trading activity within one single channel (above or below the middle line) happen during emerging trends.
Donchian Channel formula
In contrast to other envelopes indicators such as Bollinger Bands and Keltner channels, Donchian Channel formula does not contain complicated mathematical parameters like Standard Deviation or Average True Ranges.
The Indicators formula looks like this:
Upper Channel = Highest high in last N periods;
Middle Channel = ( UC - LC ) / 2;
Lower Channel = Lowest low in last N periods;
Where N is the number of periods (length) used in the indicators settings.
As traders could notice, the formula is quite simple and it does not contain complicated calculations. As a result of three equations, binary options traders can see highlighted channels, peaks and bottoms of the recent period, as well as the middle line dividing them. All three lines are used to show possible levels of resistance and support, while the current position of the price indicates the direction of the trend.
Donchian Channel settings
Donchian Channel settings include only the number of periods to calculate the values of three lines. The default period for the indicator is 20 bars (days or hours depending on the chosen timeframe). Binary options traders can consider shifting the period to get a longer or shorter range of calculation. However, any change of the default period has to come in line with the general trading strategy and individual rules of money and risk management.
If the period was enlarged, then the lag of the formula would increase, so the indicator might take into account some of the market peaks and bottoms, which are not actual any more. This choice would be suitable for the long-term analysis when traders are keen on catching strong trends, even though they might ignore insignificant fluctuations on a daily or weekly chart. On the other hand, when shortening the period, the formula might miss several extreme values of the price, which might mislead traders in terms of breakout levels. This case might be attractive for short-term traders buying options with 60-minutes expiration and less. Some of the technical analysts use Fibonacci numbers for periods, so there is an option to simply shift the default parameter from 20 to 21 bars.
How to use Donchian Channel?
As already mentioned, Donchian Channel strategy is based on following trends. This is why it is important to understand what the indicators lines show. The middle line divides the bearish and bullish channels, and a strong trend must keep recent prices above (bullish conditions) and below (bearish conditions). Thus, the breakout of the middle line might signal a shift in the technical sentiment and change of the trading conditions (trend reversals). The upper line measures the strength of the uptrend. If the line is headed north and the bulls keep charting new highs, then the uptrend is powerful and traders could expect further buying pressure on the underlying asset. The lower line points to the strength of bears with the mirrored reflection of the downtrend. Based on that, binary options traders could conclude conditions to buy a CALL or PUT options.
Conditions to buy CALL options on the breakout of the middle line from below
- If a downtrend was in play and the prices bounced off the lower line, a bullish reversal is possible;
- Once the price breached the middle line from below, start buying CALL options;
- If rates keep moving in the correct direction and the sequence of higher highs is in play, continue buying CALL options. Both upper and lower lines have to spread the surplus to confirm high volatility;
- If the price bounced back down and crossed the middle line from above, stop the trading cycle.
Conditions to buy PUT options on the breakout of the middle line from above
- If an uptrend was in play and the prices bounced off the upper line, a bearish reversal is possible;
- Once the price breached the middle line from above, start buying PUT options;
- If rates keep moving in the correct direction and the sequence of lower lows is in play, continue buying PUT options. Both upper and lower lines have to spread the surplus to confirm high volatility;
- If the price bounced back up and crossed the middle line from below, stop the trading cycle.
Conditions to buy CALL options after the price bounced off the middle line but remained above it
- If a long-term uptrend is noticed on the price chart but the rate does not renew the recent high, traders should wait for the price to retrace to the middle line from above;
- If the price tests the middle line but did not breach it from above, bouncing back up off it, start buying CALL options;
- The trading cycle should be continued if the rate goes north and re-tests the recent high;
- If the rate crossed the middle line from above, stop buying CALL options.
Conditions to buy PUT options after the price bounced off the middle line but remained below it
- If a long-term downtrend is noticed on the price chart but the rate does not renew the recent low, traders should wait for the price to retrace to the middle line from below;
- If the price tests the middle line but did not breach it from below, bouncing back down off it, start buying PUT options;
- The trading cycle should be continued if the rate goes south and re-tests the recent low;
- If the rate crossed the middle line from below, stop buying PUT options.
If you like this strategy, you might also be interested in thisW Chart Pattern
Sometimes it happens that the Donchian Channel Strategy does not provide clear trading cycles due to the indecisiveness of the market players. Prices could go through the middle line, shifting the technical sentiment several times. Such price action is possible during significant fundamental events or high volatility on strong technical levels. In this case, an additional technical indicator might be useful. For example, trend and momentum indicators might be useful to confirm or deny trading signals coming from the envelope indicator. For example, Donchian Channel scalping has to have an additional level of filtering the market noise, and less sensitive indicators have to be used in order to reduce the number of fake trading signals. Several examples of such combinations are shown below.
Examples of profitable trades
Three red arrows on the daily chart below show reflect trading signals to start buying PUT options for EUR/USD. The first signal came in when the rate breached the middle line from above and kept declining despite several tests of the resistance. The second case has a bullish breakout of the middle line, however, the upswing was not sustainable and daily prices went back into the bearish channel. The third example is much more indicative as in points to the class mean-reversion approach. The downtrend bottomed out, EUR/USD bounced off the lower line and tested the middle line from below, failing to break it through. The PUT options trading cycle was profitable. There is also one green arrow showing the strength of a bullish rebound as the currency pair had a long-term retracement and buying CALL options was lucrative.
Donchian Channel indicator combination with MACD and ADX
The chart setup below shows the same currency pair in the same period. We added the MACD trend indicator and ADX momentum instrument to see how the combination of these tools would work together with Donchian Channel. The first signal to buy PUT options was confirmed by both secondary indicators as MACD had a bearish crossover of the lines, while ADX remained in the negative territory. The second red arrow shows that the bullish breakout of the middle line was false as MACD histogram was bearish and lines did not cross each other, while ADX shifted the colour from green to red. Therefore, buying PUT options was reasonable despite the fake breakthrough. In the third case, MACD and ADX were pointing to strong bullish momentum, confirming the signal from Donchian Channel. The last example shows how MACD indicated the end of the bullish bounce at the same time with a failed test of the middle line from below.
Donchian Channel is an envelope technical indicator based on highlighting trends, showing reversal points and providing trading signals with a mean-reversion approach. The indicators mathematical formula is simple and reliable. Binary options traders can increase the efficiency of their trading systems based on Donchian Channel by adding other types of technical instruments such as trend and momentum indicators. This would allow getting additional filtering and confirmations to determine the trends direction more accurately and maximize profits.
- If an uptrend was in play and the prices bounced off the upper line, a bearish reversal is possible;