Predicting Volatility using Price Channel

[TL; DR]

- Donchian channels are technical analysis tools for measuring the level of price volatility of a security such as cryptocurrency.

- The upper line indicates the highest high of a period while the lower line shows the lowest lows.

- The centre line is the average of the highest high and the lowest low.

- The Donchian channel can act as dynamic support and resistance.





Introduction

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Cryptocurrency traders use technical analysis indicators to understand the current market conditions. The technical tools also enable investors to find alternative market investment opportunities. Most crypto and forex traders get market signals using price channels. The Donchian channels indicator helps traders to understand market volatility, trends and momentum.


What is a Donchian channel?

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Donchian channels, a tool similar to the Bollinger Bands, is an indicator that measures market price volatility. It is a fluctuating channel that acts as dynamic resistance and support levels based on price highs and lows.

The Donchian channels indicator, developed by Richard Donchian, enables traders to spot retracement levels and breakouts. It is important to note that the Donchian Channels indicator works better with candlesticks than line graphs. The reason is that candlesticks show the open, close, high and low of an asset within a trading period.

Structurally, the Donchian Channels indicator comprises three lines; with the upper one showing the period’s highest high while the lower one indicates the lowest low. The centre line, also called the meridian, indicates the average of the highest high and lowest low. To calculate the centreline, you add the highest high and the lowest low and divide by two. Then, you use the averages to plot the centreline.

This indicator works well in ranging and trending markets. Interestingly, it is suitable for different time frames . Also, it is suitable for trading various types of securities such as cryptocurrency, stocks, forex, options,and futures.


The following figure shows a Donchian Channels indicator

As you observe in the diagram, the Donchian channels indicator comprises three lines.


How to calculate the Donchian Channels?

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It is very simple to calculate the Donchian Channels indicator. The first thing you do is to establish the period you want to use. Although the default period is 20, you can choose any other suitable time frame.

Once you have the period, you identify the highest high in previous n periods and plot that to form the upper limit. You also take the lowest low in the previous period and plot the lower line. For the middle line, you find the average of the highest high and lowest low. To derive it, you use the following formula.

Centre line: ((upper band – lower band)) ÷ 2)

Remember that the number of periods (n) can be minutes, hours or days. However, with modern trading platforms there is no need for you to calculate these. The platforms use their software systems to create the Donchian channels indicator.





How the Donchian channels work

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Basically, the channel widens or narrows depending on fluctuations in the price of the asset. When the asset’s price volatility is high, the channel widens. On the contrary, if volatility is low the channel becomes narrow. Based on this behavior, traders can adopt different trading strategies such as trading the breakout. Let’s illustrate using the following diagram.


As observed on the diagram, volatility is low at point A because the channel there is narrower than at most points. However, the volatility is high at point B since the channel is wide.


How to use the Donchian channel?

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There are several strategies a trader can use.

Dynamic support and resistance

During trending markets the Donchian channels indicator helps traders to identify support and resistance levels. This is because the upper and lower lines are constantly shifting depending on market conditions. They are unlike the other support and resistance levels such as pivots, highs and lows which may be static for long periods. For instance, traders may take the upper line as a resistance level and base their trading decisions on that.

Flattening of the bands

Flattening of the upperline and lower line often signals buying and selling opportunities. The reason is that the flattening of the line indicates a possible trend reversal. A good confirmation is when the price moves above or below the centreline. The following graph shows flattening of the upper and lower lines.

If the upperline flattens it is a sell signal, unless there is a breakout. On the other hand, if the lower line flattens it is a buy signal, unless there is a breakout.

Trading the middle line

In a trending market, traders can trade the centreline. If the price of the cryptocurrency rises above the middle line, the trader can open a position.On the other hand, if the price crosses below the centreline it is a sell signal. What is important in both cases is to check for confirmation before going long or short.

The following chart gives clear indication of how you can enter or exit trading positions using signals based on the centreline.

Notice the buy and sell signals the channel generates using the centreline. These show reliable buying and selling points.

Breakout strategy

When the price of the asset crosses above the centreline it is a bullish sign. If the bullish momentum increases the price can reach the upper line which is a sell signal. However, at times the price may break above the upper line. If that happens, it is best to keep the long position open. However, it is best to avoid false breakouts. The diagram below illustrates a breakout.

As you notice the candlesticks have crossed above the upper line, showing breakouts. The same situation occurs with bearish breakouts as the following diagram indicates.

The graph is showing bearish breakouts. As a result, a trader can go short as the bearish trend is set to continue.

Trading pullbacks

Traders can also successfully trade pullbacks using the Donchian Channels indicator. For example, if the price trending above the centreline pulls back and bounces off that line, a trader can open a long position.

Setting stop losses

Traders often use the Donchian channels indicator to set stop losses. In fact, they set the stop loss just below the lower line. Therefore, the Donchian channel is an essential tool for managing trading risks.

A trader can set the stop losses at the indicated points- A, B and C.


Price Channel at Gate.io

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At Gate.io traders use a price channel that works in a similar way as the Donchian channel. The diagram below shows the price channel, with three lines as we have discussed.

There is no need to make any calculations. All you have to do is click “PC” you find below the trading chart as indicated below. The price channel will appear on your chart.

The above price channel helps traders to make exit and entry decisions.


Conclusion

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There is no doubt that the Donchian channels indicator is an important trading tool for both beginners and professionals. It helps to show the price volatility of an asset. However, in some cases you find similar technical analysis tools such as price channels.



Author: Mashell C., Gate.io Researcher
This article represents only the views of the researcher and does not constitute any investment suggestions.
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