breakout Archives - Algorithmic and Mechanical Forex Strategies

When price channels (sometimes referred to as Donchian Channels) are placed on a chart, they identify the high and the low price at which a pair traded over a specified period of time. The Channels on the Daily chart below are set to 20 periods so they would represent the high and the low at which the pair traded over the previous 20 days.

As such, they can be used quite effectively to visually identify levels of Support and Resistance on a chart. The channels can be used by “breakout” traders to identify entry levels. This would occur when price “breaks” below support in a downtrend or above resistance in an uptrend.

When the breakout occurs, this can be taken as an entry signal as the potential exists for price to continue to move in that direction for a period of time.

Let’s take a look at the example below of Price Channels on this historical Daily chart of the EURCAD…

As noted on the chart, the lower channel line represents support while the upper channel line represents resistance.

As with most every strategy, the first step is to determine the direction that we should trade the pair.

In the case of this EURCAD pair we know we want to look for opportunities to short the pair for the following reasons: 1) Price Action is below the 200 SMA and is pulling away from it; 2) at the time of this writing the EUR is weaker than the CAD; and, 3) price has been making successive lower highs and lower lows since the end of February.

Now that we have determined the direction to trade the pair, we can look to a lower time frame chart to “fine tune” our entry. For our purposes on this pair, I prefer the 1 hour chart as we may be close to an entry.

When moving down to an intra-day chart (anything below a Daily) we will change the indicator to 55 periods. We do this to slow down the indicator a bit as we have moved to a “faster”, lower time frame chart.

If/when price breaks below the lower channel line at 1.2940 on the historical 1 hour chart above, a trader could sell the pair. The stop would be placed above the upper channel line at 1.3041. As can be seen, the price channels have provided us with our “breakout” entry along with our stop placement.

The trade would be closed when price action retraces to the point that it intersects the upper channel and triggers the stop.

While there are numerous ways to manage a trade, the above method adheres to “true Donchian strategy” as put forth by Richard Donchian.

Richard Krivo

@rkrivofx

A Donchian channel measures the highs and lows of the price over a certain period in time. A lot of traders use this concept in their trading, although they are not familiar with the name Donchian.

Most Donchian channel expert advisors attempt to catch breakouts. I almost never see people use it with a ranging approach. Most traders want to ride the excitement of an ever-increasing market. The price, especially with the forex majors, often strikes the previous high or low. The price surges for a minute, only to retrace to well within the previous channel.

The hazard of using Donchian channels as breakout strategies is if you jump too early, you risk making a big fuss over nothing. If you jump too late, then you miss the move. I have not found any method for predicting when these moves will happen. My experience with fractal markets is that the period of a new movement, big or small, is totally random. The condensed trading time and low liquidity make it extremely difficult to try catching a move as it happens, at least on an intraday basis.

I have not done any testing on this, but I suspect that a ranging approach might work better. Most momentum traders are weak hands. They only play when there’s action. As soon as the action disappears or reverses itself, they all tend to leave the party. The dominance of retail traders favors a contrarian approach.

Most traders look at similar points to decide when momentum is truly occurring. They use Donchian channels, although different traders tend to use different periods. The important take-away is that the precise price that they care about tends to vary ever-so-slightly based on the period selected. The Donchian price is more or less the same, regardless of the period.

As an example, you might choose a lookback period of 55. The Donchian channel would consist of the highest high that occurred within the past 55 bars. The high could have occurred on the 55th previous bar or 10 bars ago. Time is ignored. The channel’s low corresponds to the lowest low in 55 bars or periods.

Turtle Traders

The most famous Donchian channel method comes from Richard Dennis and his Turtle traders. Dennis and friend argued over whether good traders were made or born. As wildly successful traders, they had several million dollars at their disposal to settle the bet.

The system used the 55 period high and low to determine the entry. When today’s price strikes the highest daily high in the past 55 trading days plus one tick, the trader enters at market. The system focused on commodity futures.

Most people tend to focus on the methodology that they used to pick the market direction. The original turtles argued that their success came from the unique money management and portfolio selection methodology that they used.

As a winning trade increased in value, the Turtle Trader added a second trade to his floating winner. They used recent volatility and their own risk variable, called N, to determine how far or near the second entry should occur from the original. They would do this up to 4 times, eventually letting their massive winners ride for months.

The system worked extremely well through the 1980s. My understanding is that the performance degraded towards the end of the decade.

If you’d like to read through the entire list of the Turtle rules, I suggest that you read through the Turtle Trader PDF that’s been floating around the web for years.