What Everyone Should Know About the Donchian Channel Indicator
Reading time: 13 minutes
The basics of stock trading, Forex trading, and trading in general are simple. You always aim to sell at a higher price than you buy. In that case, the Donchian channel indicator can help us a lot in trading. Additionally, it may be interesting for you to learn about a trading indicator that is simple to understand and use, being part of a successful trading strategy. We're talking about the Turtle trading system, of course. Before we delve any deeper, let's perform a quick breakdown of the Donchian channel indicator:
The Donchian Channel Formula
The indicator simply takes a user-defined number of periods, and calculates the upper and lower bands. It plots two lines on the chart, according to the Donchian channel formula. This straightforward formula states that:
- The upper line is the highest price for the last n period
- The lower line is the lowest price for the last n period
The default value for n is set as 20 in MetaTrader 4 (MT4), 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
How the Donchian Indicator Works
Donchian Channels were invented by the professional trader Richard Donchian, one of the pioneers of technical analysis. The Donchian channel plots two lines on a chart:
- One line is the highest high over a set period
- The other line is the lowest low over a set period
You as a trader should decide the time frame in question, though the default period number used in the classic Donchian system is 20 days.
Source: Admiral Donchian Indicator - Admiral Markets MetaTrader Supreme Edition Plugin (MTSE)
Installing the Donchian Channel Indicator on MT4
Although the Donchian Channel is a well-known indicator, it's not one of the standard indicators that comes with MetaTrader 4. If you want to use the Donchian Channel on MT4, you will need to download it as a custom indicator. The reason for this is that many of the Donchian channels indicators on the MT4 market might not be that accurate, and some of them might slow the platform down. 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. But that can also be a disadvantage, as this means that there is more than one Donchian channel indicator download available, and they might be coded incorrectly. If you want to enhance your trading experience even further for free, why not download the custom MetaTrader Supreme Edition plugin? It includes a fully and professionally coded Donchian Channel indicator.
Downloading and Installing the Donchian Indicator on MT4
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 click 'MQL4.community'. Once you've downloaded it, find the file's location on your computer and copy it to your clipboard.
Now go into MT4 and follow these steps chronologically:
- Select 'File'
- Click 'Open Data Folder'
- Open the 'MQL4' folder
- Open the 'Indicators' folder
- Paste the downloaded indicator file from your clipboard
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:
Source: Admiral Markets MT4 Platform - Navigator Window
Using the Donchian Channel Indicator in MT4
Turtle Trading Strategy
Who were the Turtles and what was the strategy that earned them millions of dollars?
Two Wall Street gurus once turned a group of novices into million-dollar traders. As if that's not enough, they achieved this in a matter of weeks. This group of traders were known as the 'Turtles'. In the mid-eighties, a 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 then 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 using 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. The most successful 'Turtle' was just 19 years old, and was given $2 million USD, which he turned into more than $30 million in 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.
The Turtles used two breakout variants, or "systems". The first system (System One) used a 20-day price breakout for entry. However, the entry was filtered by a rule that was designed to increase the odds of catching a big trend, which states that a trading signal should be ignored if the last signal was profitable. But this filter rule had a built-in problem. What if the Turtles skipped the entry breakout? and that skipped breakout was actually the best possible early entry? What if that was a beginning of a big and profitable trend that spanned up or down by a huge extent?
If the Turtles skipped a System One 20-day breakout and the market kept trending, they needed to use something to get back into the market. That's where 'System Two 55-day' kicks in. The System Two breakout acted as a fail-safe. That is how the Turtles stopped themselves from missing big trends that were filtered out. The strategy using their System Two is pretty simple:
- Buy a 55-day breakout, if you are not already in the market, and short a 55-day breakout if you are not in the market
- The strategy using System One is slightly different. Buy a 20-day breakout if the last S1 signal was a loss, and go short on a 20-day breakout if the last S1 signal was a loss
The Turtles calculated the stop loss for all trades using the Average True Range (ATR) of the last 30 days, a value which they called 'N'. The initial stop-loss was always ATR (30) * 2, or, in their words, two volatility units. Additionally, the Turtles managed to compound their profits back into winning trades to maximise their winnings, commonly known as pyramiding. They could pyramid a maximum of four trades, separated from each other by a 1/2 volatility unit.
The Exit Strategy
The Turtles usually exited their trades using breakouts in the opposite direction, which allowed them to ride very long trends. The exit strategy used in their System Two is as follows:
- Exit long positions if/when the price touches a 20-day low
- Close shorts positions if/when the price touches a 20-day high
The exit strategy using System One used a slightly different methodology
- Close long positions if/when the price touches a 10-day low
- Close short positions if/when the price touches a 10-day high
The Turtle Strategy Money Management System
Turtles used the 2% initial risk for all trades. However, slightly aggressive pyramiding of more and more units had its downside. If no big trend materialised, the little losses from false breakouts would eat away even faster at the Turtles' limited capital. How did Eckhardt teach the Turtles to handle losing streaks and protect their capital? They cut back their unit sizes dramatically. When markets turned around, this preventive behaviour of reducing units increased the likelihood of a quick recovery, getting back to making big money again. The rules were simple back then. For every 10 per cent in account drawdown, the Turtles cut their trading unit risk by 20 per cent. This of course applies to bigger numbers. The unit risk would be decreased by 80%, with a 40% drawdown.
An Example of the Turtle Trading Strategy
Source: GBPUSD Daily Chart - Admiral Markets MT4SE Platform - Data Range: 24 Mar, 2016 - 23 Aug, 2017
In the chart above you can see the daily GBP/USD currency pair chart in MT4, with the Donchian channel custom indicator applied several times. To set up the Turtle system chart, apply the Admiral Markets Donchian channel indicator three times. We used the Turtle trading rules with these settings for this particular example. You can change the colours and the line width to your preference.
Source: Admiral Donchian Indicator - Admiral Markets MT4SE Platform
Source: Admiral Donchian Indicator - Admiral Markets MT4SE Platform
Source: Admiral Donchian Indicator, Admiral Markets MT4SE Platform
Notice how the price breaks out above and below the Donchian channels in various places? As noted earlier, the Donchian channels show the highest high with the lowest low for your specified time. When the price breaks through the channels, we are able to see new highs or new lows being set. This is an indication of a possible start of a new trend. For Turtle Trading on MT4 we use following rules: Set up a daily chart. Wait for the price to exceed the high or the low price of the past 20 periods (Donchian Channel 20). Open a long or short based on the breakout. The arrows show possible entries.
Source: GBP/USD Daily Chart - Admiral Markets MT4SE Platform - Data Range: 24 Mar 2016 - 23 Aug 2017
If the previous 20-bar breakout resulted in a profitable trade, the new breakout would be ignored. If you ignore a 20-bar breakout, you might be at risk of missing a big trend, should the price continue to move in the direction of the breakout. That is when the aforementioned 'System Two' might become useful. If the price exceeds the 55-bar high/low, you open a long/short position depending on the breakout direction respectively. In the case that you didn't open a trade at the 20-bar breakout, every 55-bar breakout is taken, whether or not the previous one was a winner.
Source: GBPJPY Daily Chart - Admiral Markets MT4SE Platform - Data Range: 17 May 2016 - 22 Sep 2017
Using MT4SE to Improve the Turtle Channel Indicator
In order to use proper money management (described at the beginning of the article) traders might need to add a few additional indicators:
- The ATR (Average True Range) set on a 20 period
- Admiral Pivot indicator
The ATR (20) is used for the exit strategy. Bear in mind that exits can be far from the entry price, so the initial stop-loss is placed at '2 x ATR 20' for both systems. For example, if the ATR is 101 pips, the initial stop-loss would be placed at 202 pips from the entry price, and then manually updated once the 10 or 20-bar low/high is lower/higher than the initial stop. The Admiral Pivot indicator could be set on monthly if you are trading the Daily time-frame, and it can help with exits as well. Admiral Pivot uses standard price information, such as high, low, and close, and uses this information to project possible support and resistance levels, but also much more, allowing traders to customise different the different types of time-frames used for calculation.
Source: GBP/JPY Daily Chart - Admiral Markets MT4SE Platform - Data Range: 8 Aug, 2016 - 15 Sep, 2017
Bear in mind that the Admiral Donchian is also available on the MetaTrader 5 trading platform as well.
Source: USD/JPY Daily Chart - Admiral Markets MT5SE Platform - Accessed: Sep 2017
A Summary of Donchian Channels
We now know that the Donchian channel indicator is a simple but effective indicator that plots the highest high and the lowest low over a set period of time. It is also useful for identifying price breakouts and is used in some trend-following systems too. The Donchian channel indicator is available in numerous versions for MT4, and produces false signals that can be minimised with filters. Markets have changed a lot over the years, so even the Turtle strategy needs some serious modifications. Additionally, the Donchian channels can be used in many different ways, so feel free to experiment on a risk free Demo trading account before opening a high-risk, high-reward live account.risks.