The Donchian Channel Breakout
The Donchian Channel Breakout System is a classical trend-following strategy.
Richard Donchian was a pioneer of systematic trading. He was the author of one of the first channel breakout systems. When we draw lines connecting those breakouts – highest highs to highest highs and lowest lows to lowest lows- a channel is formed. The figure below shows a Donchian breakout channel of the EUR/USD 1-hour chart.
As a new high is made the upper band moves higher, while the lower band stays at the same level, until a new 20-day low comes out, creating the stairway pattern we observe in fig 5. Sometimes, the upper band goes up while the lower goes down. This is caused by a big outside bar.
According to Perry Kaufman, in 1971, Playboy’s Investment guide reviewed Donchian’s 4-week rule as a “childishly simple” way to invest.
The Donchian trading method:
- Go long (and cover short positions) when the current price is higher than the high of the latest four weeks
- Sell short (and close long positions) if the current price falls below the low of the latest four weeks.
Donchian channel breakout system is amazingly simple and effective, even today, after more than 50 years of it being public knowledge. The Donchian 4-week rule system complies with three basic rules of trading:
- Follow the trend
- Let profits run
- Limit losses
Testing the N-BAR Rule
The widespread use of software platforms for trading, incorporating some programming allows for simple back-testing and optimization of trading ideas. Here we want to test the rules on intraday trading.
Fig 8, below, shows a naked N-day breakout system parameter optimization on 18 years of the EURUSD 1h chart. The best behavior is a 9-day breakout.
The graph shows a relatively smooth hill that graphs the Return on Account achieved by the strategy using a constant one-lot bet.
The best parameters using return-on-account as metric are Longs: 9, Shorts: 9, resulting in the equity curve shown above.
The total trade analysis shows the following summary:
We observe that the percent gainers are 35.77% and the Win/loss ratio is 2.07. This is consistent with a trend-following system.
On the USD-JPY we observe the same good results:
Main metrics of the Donchian System, on the EUR-USD:
Main idea: This is a trend-following system. To catch the trend, we want to see a breakout or breakdown from previous levels.
TimeFrame: 1-hour chart
Rules: The only rule of this system is: buy if the price closes above its 9-bar high, and sell-short or reverse if the price closes below the 9-bar low. No stops.
Note: These metrics are the result of the use of a constant one-lot trade size. Therefore they will change if the trade size is proportional, for example, trading 1% of the running capital will improve results a lot. In fact, the use of position sizing strategies is key to optimize the dollar performance of this system.
The statistical graphs shown here are the result of a 20,000-times Montecarlo resampling.
Diversification and risk
There is just one solution to overcome long and deep drawdowns: To trade a basket of uncorrelated markets with risk-adjusted position sizing, so no single market holds a significant portion of the total risk.
To show you how a basket of uncorrelated stock may reduce overall risk and smooth the equity curve, let´s discuss the concept of portfolio variance.
As a simple situation let’s consider the total variance on a 2-position portfolio, which can be calculated using the following equation:
𝜎2 = w1 𝜎12 + w2 𝜎22 + 2 w1 w2 𝜎1𝜎2*cov12
Where w1 and w2 are the weights for each market, and cov12 is a quantity proportional to the correlation (ρ) between those assets.
In fact, cov12 = ρ1,2 * σ1 * σ2
Then, if the covariance is zero, the variance of a portfolio with n assets is:
𝜎2 = w1 𝜎12 + w2 𝜎22 + … + wn 𝜎n2
To observe the effect of diversification, let’s assume that we have equal weights on five uncorrelated markets with an equal risk of $10, compared to investing just one of the markets with its full $10 risk.
Thus, to spread our risk, we divide our position by five on each market. Therefore, now, we are exposed to a $2 risk in each market. Thus, the total risk would be, again, 10, if the markets were perfectly correlated with each other, as is the case of a single asset. But, if they were fully uncorrelated, the expected combined risk would be computed using the above equation:
Risk =√ (5 x 22) = √20 = 4.47
So, for the same total market exposure, we’ve lowered our risk by more than half. Of course, in actual markets there aren’t “totally uncorrelated positions”, and, sometimes, all markets move in sync with each other. But the proposed method is the way to reduce risk, and smooth our equity curve, as much as we can: By diversifying, and making sure the correlation between our assets is as low as it may be.
How to use Metatrader 4 to trade this strategy:
The Donchian Channel indicator can be directly downloaded to your JAFX MT4 from:
When clicking download, a pop-up window appears:
Clicking “Yes I have MetaTrader 4” the indicator installs directly in your JAFX trading platform.
To load the indicator to a chart, on your MT4 go to Insert -> Indicators -> Custom- Donchian Price Channels tfmt4:
Then, a popup window appears, presenting the parameter selection:
And, finally we get the desired channel surrounding prices:
A buy signal happens when the price closes breaking the current upper border of the channel. Sell signals happen when a closing price goes below the line of the current lower limit of the channel. See figure below.
In the figure above, we see three long trades and four short trades. The first two long trades are positive, and, also, first and the last short trades. The green lines connect entries with exits if the trade is positive, and the red ones connect entries and exits on losing trades.
It’s not usual but, from time to time we may expect a streak of up to 20 losing trades. Therefore we need to apply proper money management.
As an example, let’s say, you don’t like to have a drawdown higher than 25% of your running capital. Then, you need to divide that figure by 20, and that must be your maximum risk for a single trade. Therefore, in this case, this is 1.25% of the current capital allocated to this Forex Donchian strategy.
NOTE: This study about Donchian Channel Breakout System was created using, and with the kind permission of, Multicharts 11 Trading Platform.