How to use Donchian channel to trade

Back in the 1980s, commodities speculator, Richard Dennis ran his famous ‘Turtle Traders’ experiment – a kind of real-life Trading Places …

The idea behind the Turtle traders experiment was that ‘anyone’ (from the carefully hand-selected group that Dennis chose) can be a successful trader, and that’s it all comes down to rules and discipline.

And it worked … rules and discipline won out for the Turtle Traders …

… so what were those rules, and why were they so effective.

One of the key instruments that Dennis got his traders to use was the Donchian channel. It’s an indicator that’s so ridiculously simple, you probably wouldn’t normally give it the time of day … yet it’s a fantastic lesson in how simple rules about letting trends run and cutting losses fast will always come through over the medium- to long-term.

Here’s how it works …

The Donchian channel measures the highest high and the lowest low over the last 20 periods (or whatever number of periods you’ve set it for).

Yes, that’s it – it really is that simple.

The Turtle traders would look to buy into the market when prices broke above the 20-day high – i.e. when the upper Donchian channel was breached.

It’s so mind-numbingly simple that it makes a mockery of all our carefully crafted, overly complicated indicators.

The Turtle trader then uses a tighter Donchian channel (the 10-period channel) as a trailing stop.

So, it’ll look like this …

The green arrows on the chart above show where the buy signals are, and the red arrows show where these trades would have stopped out, hitting the 10-period Donchian trailing stop.

In the sample shown above (just looking at buy trades) we see one big winning trade, and two small losing trades – the kind of result that’s the meat-and-potatoes of the trend trader.

Adding an overarching trend indicator (like we looked at in my last post) would also help to filter out trades that go against the trend.

So, if building a successful trading method is this simple, why do so many traders fail?

The most difficult part of the Turtle method is sticking to those exits. Waiting for a 10-day low to be hit can be torturous – as you’re watching your profits evaporate. There’s a strong tendency to want to jump out earlier.

I use trailing stops in my Heikin Ashi Mountain method, and it’s been a tough learning curve for me. To really succeed at trend trading, you’ve got to learn to master the exit, and the truth is that it involves lots of small losing trades … watching profits dwindle on open positions … safe in the knowledge that when the big winners come, you’ll clean up.

One of the aims of my Heikin Ashi method was to make this process as painless as possible – because I’m all too aware of my human frailties when it comes to exiting trades!

What I hope the Donchian channel shows (whether you use it or not) is that indicators can be as simple as you like – real success comes from discipline rather than filling your charts with indicators.

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