Donchian channel - position size scaling, use to knock out
Continuing our series of articles on technical indicators, today we will present another of them - Donchian Channel. One may be tempted to say that it is quite unpopular, but it is not entirely clear why. Without a doubt, this is an interesting indicator following the trend, which was developed by Richard Donchian, one of the pioneers of technical analysis. In this article, we'll take a closer look at the assumptions for using the channel and provide some tips on improving the quality of signals that this indicator generates.
Be sure to read: Parabolic SAR - methodology and methods of use
Donchian Channel - basics
At first glance, the appearance of the channel may resemble another popular indicator which is the Bollinger band. The main premise is simple. we have two lines that indicate maximum and minimum of the pre-defined range - ultimately it is 20 days. The indicator accepts the number of time intervals selected by the trader and on this basis calculates the upper and lower value of the range.
It looks like this:
- top line - highest price last n periods,
- bottom line - lowest price last n periods.
Of course, the target value of 20 can be easily changed according to your preferences. As for the middle line, which can also be seen on the graph, it is the average obtained from the high and low lines according to a simple formula:
center line = (peak from n periods + hole from n periods) / 2
Using the indicator in everyday analysis is mainly about defining the range well and then wait until the price breaks out on one side.
Improving the signals generated by the indicator
As is usually the case with indicators, not all signals generated prove to be effective. The channel is mainly about breaking. If we have a little more experience and look at the false one, we will usually see that accompanies them low momentum. To minimize and separate better signals from worse signals, the first thing we can do is add RSI to the second filter. If you are a trader who trades typically for breakouts, then no momentum, or divergence on the indicator, may signal falsehood in advance if the price exceeds the given range.
Another technique to improve signal quality, which in my opinion is even more effective, is channel connection with moving average. If we don't have enough experience yet and we can't do it well "Read information" from the indicators, here the situation is simple. Medium just like RSI is our additional filter that allows to divide the upward or downward scenario. When the price is above average, we are only looking to break up. In a situation where the price is below average, just knock down. After adding the average to the previous example, it looks like this. The number of signals has decreased, while their quality has improved.
Scaling and size selection of items
Choosing the right size of position has always been a source of controversy. There is a certain scaling method that can help you trade to break out and follow the trend. Not to be confused with piramidowaniem or grid. At the outset, we always specify the maximum size that we are able to commit to a single input. Scaling consists of initially entering part of the target position size, and then when the price goes in the assumed direction, adding to the position and moving stop loss so as to protect current profits.
For example, if the maximum position size is 1 lot, the initial entry can be 0.2 lots, then after the move we secure the profit, add another 0.2 lots and so on until the maximum size is reached or take profit is broken.
This approach has two advantages:
- with a fake the stop loss achieved will be small, because we do not immediately enter the maximum size of the position,
- if we are right and the price goes strongly in the direction assumed by us, it allows us to maximize profit.
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