Donchian Cannels and Turtle Trading

Donchian Channels

Donchian channels were developed by Richard Donchian, a pioneer of mechanical trend following systems. The two outer bands are plotted as the highest high and lowest low for a set period, originally 20 days, with the optional middle band calculated as the average of the two.

Donchian Channel Trading Signals Applicability

The system is only suitable for trending markets.

Despite its obvious shortcomings, as a trend-following system, - it works well in up or down trends, but not sideways trends - the Four-week Rule is a tool that should be in every technical analyst's repertoire. It was developed by Richard Donchian in the early 1970s for commodities and futures, and has been successfully applied to stock analysis.

Also known as the "Price Channel" or "Donchian Channels," the Four-week Rule may be a basic tool. But in the right hands, it can be powerful. In other words, the rules may be simple, but applying them is not. It works to the extent of the analyst's abilities.
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Donchian's Four Week Rule

The Four-week Rule is a method that includes a set of charting rules that are generated from the price channel as well as a set of trading rules. The mistake that some analysts make is to use the price channels without the trading rules. It is the combination of both sets of rules that make the method effective.

The charting rules

The price channel generates the following signals when applied to stock charts:
  • buy signals are produced when the price closes above the upper band of the price channel; and,
  • sell signals are generated when the price closes below the lower band of the price channel.

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  • When the price is at its highest in a four week period, buy long and cover short positions.
  • When the price falls below the lows of a four week period, sell short and liquidate long positions.
  • This last rule only applies to future traders, which is "to roll forward, if necessary, into the next contract on the last day of the month prior to expiration.

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The objective is to enter the trend on a breakout and to ride the trend for as long as possible, avoiding shakeouts.

Complimenting the Four-week Rule

So what can you do to increase the effectiveness of the Four-week Rule so that you don't miss opportunities due to the lagging indicators? And equally as important, how can you ensure that you aren't going to lose money in a volatile or sideways-trending market due to false signals?

One way to add certainty to the Four-week Rule is to use complimentary indicators or methods to generate additional signals that provide a warning or confirmation.

For example, you can use another trend-following system, the Five- and 20-day Moving Averages Method, also developed by Donchian, in conjunction with the Four-week Rule, to create combined signals that help you determine if the price has really generated a strong trend. Note: The rules in these two systems do not conflict with one another.

The Five- and 20-day Moving Averages Method

The Five- and 20-day Moving Averages Method includes several general and supplemental rules. These rules were initially intended for currency markets but can also be used to analyze stocks.

The method consists of the following rules:

Basic Rule A: Act on all closes that cross the 20-day moving average by an amount exceeding by one full unit the maximum penetration in the same direction of any previous closing when the closing was on the same side of the moving average.

Basic Rule B: Act on all closes that cross the 20-day moving average and close one full unit beyond the previous 25 closes.

Basic Rule C: Within the first 20 days after the first day of a crossing that leads to a trading signal, reverse on any close that crosses the 20-day moving average and closes one full unit beyond the previous 15 closes.

Basic Rule D: Sensitive five-day moving average rules for closing out positions and for reinstating position in the direction of the 20-day moving average are:
  1. Close out positions when the currency closes below the 5-day moving average for long positions and above the 5-day moving average for short positions, by at least one full unit more than the greater of either the previous penetration on the same side of the 5 day moving average, or the maximum point of any penetration within the preceding 25 trading days. Should the range between the closing price in the opposite direction to the Rule D closeout signal be greater than the prior 15 days than the range from the 20-day moving average in either direction within 60 previous sessions, do not act on Rule D closeout signals unless the penetration of the 5-day moving average exceeds by one unit the maximum range both above and below the 5-day moving average during the preceding 25 sessions.
  2. Reinstate positions in the direction of the basic trend (a) when the condition in paragraph 1 are achieved, (b) If a new Rule A basic trend is given, or (c) if new Rule B and Rule C signals in the direction of the basic trend are given by closing in a new low or new high ground.
  3. Penetrations of two units or less do not count as points to be exceeded by Rule D unless at least two consecutive closes were on the side of the penetration when the point to be exceeded was set up.

Combining the 5- and 20- day moving average cross system with the Four-week Rule can help to confirm information about the potential trend change. These modifications are not intended to replace basic trend-following techniques - but to provide more information about the trend when price channel signals are generated.

Turtle Trading

Curtis Faith in his book Way Of The Turtle describes a variation of the Donchian system used by the legendary Turtle Traders.
  • Enter long when price crosses above the 20-Day upper Donchian Channel and exit when price penetrates a 10-Day lower Donchian Channel.
  • Enter short when price crosses below the 20-Day upper Donchian Channel and exit when price penetrates a 10-Day upper Donchian Channel.
  • Use the 25-Day/350-Day exponential moving average as a trend filter. Go long only if the 25-Day EMA is above the 350-Day exponential moving average and go short only where below the 350-Day EMA.

The system also uses ATR trailing stops with a multiple of 2. Faith, however, demonstrates that replacing the 10-Day Donchian Channel and ATR stops with a simple time-based exit, where all trades are exited after 80 days (16 weeks), achieves similar results — with no stop losses at all.

Example

Goldman Sachs displays the Turtle Trading settings for an up-trend, 20-day upper and 10-day lower Donchian Channels, with 63-day exponential moving average as an added trend filter.

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Mouse over chart captions to display trading signals.
  1. Go long [L] when price crosses above the upper Donchian Channel while above the 63-day exponential moving average
  2. Exit [X] when price crosses the lower Donchian Channel
  3. Go long [L] when price recovers above the upper Donchian Channel
  4. Exit [X] when price crosses below the lower channel.

Donchian Channel Setup

The default setting for both Donchian Channels is 20 days. The middle line is optional.

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Donchian Channel Formula

  1. The upper band is calculated as the highest high for the selected period.
  2. The lower band is calculated as the lowest low for the selected period.
  3. The selected period does not include the day on which the band is plotted (otherwise the band would never be crossed). For example, the 20-Day Donchian Channels for today are the highest high and lowest low for the preceding 20 trading days.
  4. The middle line is calculated as (Upper Band + Lower Band) / 2.


Sources and Additional Information:



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