The Donchian channel is a trend-following indicator which has been heavily used by the infamous Turtle traders. The screenshot below shows the channel on Apple with donchian channel 20-day range where it marks the highs and lows of a 20 day period. Typically, a trader would look for a well-defined range and then wait for the price to break out to either one side for a trade entry trigger. But, there is more to the Donchian channels and we will discuss how to increase the quality of the signals and how to structure a trend-following position sizing strategy.
The first screenshot below shows the AAPL chart and the 20-day Donchian channel. At first glance, it’s apparent that a significant amount of false breakouts exist when momentum is not supporting the move. In the first step, we added the RSI strength and momentum indicator to filter out low-momentum breakouts which are often false breakouts. In the next steps, we show how other tools and techniques can help improve the accuracy of the system.
Tip: If you are a reversal trader or fade breakouts, combining the Donchian channel and the RSI can be a great asset in your trading arsenal. A lack of momentum or divergences can signal false breakouts if followed by a failed break of the range. 100-period moving average which is an excellent filter tool that helps you separate between long and short scenarios. 100-period moving average, you only look for short breakouts. Using moving averages as a directional filter is used by many professionals and also Marty Schwartz, who was featured in the Market Wizards series, mentions the moving average filter as one of his favorite tools. The screenshot below now also includes the 100-period moving average.
The amount of signals has been reduced while, at the same time, the quality of the signals has been improved significantly. There are only 3 false signals left and in the next step, we will show how to minimize the impacts of losses by using money management techniques. Those are just two examples of how adding trading tools and indicators can help you improve the quality of your trade entries. The approach highlights the importance of combining trading tools and concepts that support your trading style and objective in order to filter out low probability entries. Especially for breakout and trend-following traders, there is a specific position sizing strategy that can help you improve the quality of your system even further. On a fake breakout, your position will be relatively small because you haven’t yet reached the full position. Only when the breakout is strong and successful you reach your maximum position size and fully capitalize on winning trades.
The screenshot below shows the AAPL chart again and it illustrates how the impacts of the false signals could have been minimized by applying the scaling in technique. Whereas the successful breakouts often saw long moves and the trader would have been able to scale in completely, the unsuccessful breakout failed after the first entry and the loss would have been only a small amount. As a breakout and trend-following trader, look for momentum and sentiment tools that help you read what is going on and filter out trades with a lower probability. We have been trading for over 20 years.
We are passionate about giving back as we would be nowhere near to where we are today without the help of other veteran traders that helped us in the beginning. If you consider joining our community, we feel honored by your trust and we’ll make sure that every free minute we have will be spent on making your investment worthwhile. A big thanks go out to all contributors of Unsplash! We use Flaticon for our icons. If you continue to use this site we will assume that you are happy with it. This article does not cite any sources.