Donchian Channel and Channel Breakout

Donchian breakout levels The term “breakout” is often associated with Richard Donchian, the first person to popularize the systematic use of breakout levels. His basic approach was called the Donchian “four-week rule,” which consisted of the following:

1. Go long (and cover short positions) when the market makes a new fourweek high (that is, when price exceeds

the highest price of the previous four weeks).

2. Go short (and cover long positions) when the market makes a new fourweek low (that is, when price drops below the lowest price of the previous four weeks). The four-week highs or lows simply represent natural resistance and support

levels. This kind of trading system is often referred to as stop-and-reverse (SAR), because when a trade signal is generated, the existing position is liquidated (stopped out) and a new position (a reverse of the previous one) is established. This basic trading rule — which gained widespread popularity as the “20-day breakout” — was integral to many popular mechanized trading strategies, most famously those of futures trader Richard Dennis group of trend-followers known as the “Turtles.” Trend-following traders (especially in the futures markets) used this simple technique, or a variation of it, to exploit strong trends in the 1970s and ’80s. However, the widespread popularity of the 20-day breakout level has diminished its effectiveness to the point that many traders look for false breakouts (when price pushes through a breakout level, only to reverse back through it) at these levels, to take positions against the direction of the initial breakout (referred to as “fading” the breakout). Breakouts are not limited strictly to moves to new highs of a certain number of bars (i.e., 10-bar, 20-bar or 40-bar breakouts). As mentioned, price can also “break out” through the support and resistance levels of trading ranges, or other past technical milestones such as long-standing highs or lows.

Figure 1 shows 40-day breakout levels on a daily chart. Figure 2 shows 20-bar breakout levels on a 10-minute chart.

Figure 3 shows a breakout above theresistance level defined by a past significant high.

The Donchian-type breakout is also commonly referred to as a “price channel” breakout.

Application

Traders using breakouts are basing their trades on the following principle: If price momentum is strong enough (either up or down) to push through a significant technical level, there is a good chance price will continue in that direction for at least a while. As a result, these price levels represent logical trade entry and exit levels with well-defined risk, both for traders who expect follow through in the direction of the breakout and, as will be described shortly, traders who are looking to fade breakouts.

Key points

Price breakouts are typically used as trend-following signals. The greater the number of days (or price bars) used to determine the breakout, the longer-term trend the trading system will reflect and attempt to exploit. For example, a 20-day (or 20-bar) breakout would capture shorter trends than a 40-day breakout, which in turn would reflect shorter trends than an 80-day breakout. Generally, in terms of trend-following approaches, the longerterm the breakout, the more significant the price move and the greater the likelihood of sustained follow through. Breakout trading can also simplify

risk control because stop-loss levels are often easy to identify. For example, if price breaks out of the upside of a trading

range, traders who go long on the breakout can place protective stops in a number of technically logical places, in relation to the range. First, the stop could be placed below the low of the trading range. Second, a more conservative

stop placement would be in the middle of the trading range (or in the upper 25 percent of the trading range, etc.). Finally, the most conservative alternative is a stop just below the original breakout level, which might be used by

a very short-term trader. All these choices have one thing in common: The placement of the stop corresponds to a price move that negates the validity (to varying degrees) of the original breakout. Whenever the original

reason for a trade is nullified, that position should be eliminated. (Note also, the second and third options would be likely short entry points for traders looking to fade the upside breakout.) Figure 4 shows a downside breakout out of a trading range and possible stop points. Figure 5 shows the reverse situation. The stock first breaks out to the downside of the trading range, but this turns out to be a false breakout. The stock reverses back into the trading range and eventually breaks out through the upside of the trading range. Again, the boundaries (and the midpoint) of the trading range provide logical stop levels — both for the initial downside breakout and the subsequent upside breakout.

Because of the possibility of false moves at popular breakout levels, traders looking to capture trending moves sometimes use confirming signals to improve the likelihood of success. For example, after an initial upside breakout, the trader may wait for the market to stay above the breakout level (or close above it) for a certain number of bars, or penetrate it by a certain percentage. Such techniques delay entry and limit profit potential (and will result in some missed trades), but they can also cut down on false signals.