The basics of trading are simple. You always aim to sell at a higher price than you buy.
Easier said than done, right?
Then it might interest you to learn about a trading indicator that is simple to understand and use, and is a part of a legendarily successful trading strategy. We're talking about the Donchian channel indicator, of course.
By the end of this article, you'll know just how easy it is to set up and use Donchian channel indicator in MetaTrader 4. Or perhaps you prefer to try yourself on a risk-free demo account?
Either way, you probably want to know about the "legendarily successful" part. It is a pair of Wall Street gurus who took a group of novices and turned them into million-dollar traders.
And as if that's not enough, they did it in a matter of weeks. This group of traders were known as the Turtles. If you don't already know the story, read on.
In the mid-eighties, well-known commodity speculator Richard Dennis made a bet with his friend Bill Eckhardt. The heart of the matter was a question of nature versus nurture – whether great traders are born that way, or whether they can be trained.
The bet got serious.
Serious enough that Dennis took out ads in the Wall Street Journal and the New York Times, for applicants to be a part of this grand experiment. After an initial training period of just two weeks in Dennis' methods, applicants were let loose with real money. After a month's trial period, the best Turtles were given upwards of $1 million USD to trade with.
If that sounds a little crazy then hang on, because there's more.
The most successful Turtle was just 19 years old and was given $2 million USD, which he turned into more than $30 million USD profit. As it turns out, the trading rules they used were actually fairly simple.
In essence, they used what is called a Donchian Trend system. And yes, you guessed it – at the heart of that system is the Donchian channel Indicator.
So why is it so effective?
Basically, the indicator that makes it easy to look for price breakouts, the idea being that if the price breaks clearly in one direction, it may result in a prolonged trend. Breakout systems using the Donchian channel indicator, produce a trading signal when the market moves above or below certain ranges.
So, are you ready to check-out how this indicator works, how to use it and how you can improve the strategy with a filter?
Then let's do it.
You decide the time frame in question, though the number used in the classic Donchian system is 20 days.
Now, why do we care about these channels?
The Turtles we talked about earlier were trend followers. General trend following systems look for periods when support and resistance levels do not hold in the market.
Often when the market approaches a level of support of resistance, it will bounce back. Occasionally, though, it will break through the support or resistance level and keep on going. When the market sets new highs or lows, it can be an indication that this is happening.
And here's the good bit – Donchian channels allow us to see these occurrences readily by the price on a chart penetrating above or below them.
Although the Donchian channel is a well-known indicator, it's not one of the standard indicators that comes with MetaTrader 4. So if you want to use Donchian channel on MT4, you will need to download it as a custom indicator.
And if you want to enhance your trading experience even further for free, download the custom MetaTrader 4 Supreme Edition plugin.
One of the key advantages of MetaTrader 4 is the accessibility of its programming language. The MT4 user base is large, active and includes a huge variety of custom indicators. This means there is more than one Donchian channel indicator download available.
You might find a little variation. i.e. some have a few extra bells and whistles, but they all work in basically the same way.
Downloading the Donchian channel indicator is easy. First find the Donchian channel file you want in the MetaTrader community by clicking on the Help tab in MT4, then clicking MQL4.community. Once you've downloaded it, find the file's location on your computer and copy it to your clipboard.
You're almost there!
Now go into MT4 and chronologically:
When you restart MT4, you should see the Donchian channel indicator listed in the navigator. So let's take a closer look at the indicator now.
Basically, it plots two lines on the chart according to the Donchian channel formula. This straightforward formula says that:
The default value for n is set as 20 in MetaTrader 4, but you can set it at whatever value you prefer. However, some versions of the Donchian channel indicator also plot a third line.
This centreline is simply the mean of the upper and lower values – namely, the centreline = ( n-period high + n-period low) /2
Above you can see a daily EUR/USD chart in MT4, with a Donchian channel custom indicator applied. The chart's time period is the standard value of 20 days. Its green upper line shows the 20-day high, while red lower line shows the 20-day low.
Notice how the price breaks out above and below the Donchian channels in various places?
As noted earlier, Donchian channels show the highest high with the lowest low for your specified time. When the price breaks through the channels, we are seeing new highs or new lows being set. These are an indication of the possible start of a new trend.
But that's just part of the story, because the chosen time period will establish what kind of trend we are talking about. The longer the period you use, the longer the trend's possible duration.
Now, 20 trade days is effectively a month and the channels show the highest plus lowest prices achieved in this time. In my experience, market participants typically gauge value against recent highs and lows like these, i.e. this is how support and resistance levels build up.
Traders use recent highs and lows as yardsticks, to judge new prices as being high or low. That's why prices tend to bounce off these levels repeatedly, before you see a breakout.
You see, traders expect this to happen. This makes the Donchian channels significant.
If the price breaks through to a level that has not been seen for some time, no obvious support or resistance points remain.
But don't get me wrong. Yes, counter-trending traders may still win out in such circumstances and prices may retrace back to previous levels, but not always.
Every so often the price may continue in the direction of the breakout and carry on for some time.
What's more, once a trend really starts motoring like this - there become cumulatively fewer obvious turning points for trading psychology to switch.
Which is why long trends can be so dramatic in magnitude.
Above you can see daily EUR/USD, with 20-day Donchian channels and two moving averages (MA). The two MAs act as a trend filter, because the problem with all trend following systems is false signals.
A Donchian channel breakout strategy will also provide a few false signals.
The filter helps reduce these false signals, by only permitting trades that are in the direction of the trend indicated by the MAs. The pale dotted line is a 25-day MA, while the white dotted line is a 350-day MA.
When the faster MA is above the slower MA, the trend is up, and you should ignore breakouts below the lower Donchian channel at such times. When the faster MA is below the slower MA, the trend is down, and you should ignore breakouts above the upper channel.
So we now know that the Donchian channel indicator is a simple but effective indicator that plots the highest high and lowest low over a set period of time. It is useful for identifying price breakouts and is used in some trend-following systems.
The Donchian channel indicator is available in numerous versions for MT4 and produces false signals, that can be minimised with filters.
And what about those Turtles?
Well, they basically used a 20-day breakout rule for entries - with a few added rules and exceptions. They also used a simple position-sizing algorithm as part of their system, but that's another story.
If you enjoyed this article, check-out our rundown of the Best Forex strategies that work and also be sure to work together with us on improving your general Forex knowledge. You can do it live or at your own pace.