5000% Returns using the Donchian Channel Strategy
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In this video we look at the Donchian Channel breakout system, a system developed by Richard Donchian in the mid 20th Century, he was later nicknamed “The Father of Trend Following”. Following price action rather than fundamentals was key to Richards system, and a he later said:
“Research alone won’t ensure a profit, your main goal should be to make money, not to get an A in How to Read a Balance Sheet.”
Many traders have since used Richard’s teachings, perhaps the most famous adoption was the Turtle Trading System which was born from his method.
Today we look at the Donchian system, but also apply simple parameters that have yielded over a 5000% return since 1990, whilst also avoiding some of the major market crashes of the past. In fact, out of the 600 trades placed the average profit was over 62%, the average loss was under 12%, whilst the win rate came to just under 49%.
So, what are Donchian channels? The Donchian Channel indicator can be found on most charting packages, therefore making it an easy mechanical system to follow. The channels are made up of three bands, an upper band, a lower band, and a mid-range band.
The upper band marks the highest high in the previous period being measured, whereas the lower band looks for the lowest low in the period measured. The period is called ‘N’ and is defaulted to 20, therefore if you’re looking at the daily chart the channel will look at the last 20 days to mark the channel. Traders will use the lines to identify breakouts and retracements of the upper and lower bands.
A breakout trade could look like this, with a flat upper band followed by a closed breakout bar. Or, traders looking to short a position may see a chart like this, but this time a flat lower band followed by a closed breakout bar to the downside. We can see similar breakout bars to the downside as the bearish trend continues.
By using this Donchian method and some simple rules, let’s look at how we could have achieved this 5000% return.
The rules are straight forward, we only use stocks from the Russell 1000 index, these are the 1000 largest stocks in the US meaning that liquidity should never be a concern.
We only look for stocks within the index if the index is above the 100 week moving average, this ensures we have momentum in our favour.
The individual stocks need to close above their 50 week high to qualify. This is where the Donchian channel comes into play, the top band will need to be set at 50 when looking at the weekly chart, the breakout of the band (with a closing candle) would qualify the stock as a valid breakout selection, the entry would be the following Monday at the open.
The exit of the trade would be when price closes below the 40 week low, therefore the lower band would have 40 entered as the parameter.
Position size must be 5%, meaning a maximum 20 position portfolio, and if there are more qualifying stocks than positions available, we must sort by the stocks which have increased the most over the last 50-week period and add the highest gainers.
Let’s put this concept together by using the stock Netflix as an example.
We enter the Donchian settings as a 50-week high and a 40-week low.
If we were already in a trade, we would have exited here at the first close below the 40-week low band. Our next buy point would have been here at the first close above the 50-week high band.
We then await a close back below the 40-week low band to exit the position, we see that here, just before the stock plummets losing a further 50% of its value.
Despite the promising long-term results of following this approach, my concern is twofold; the distance a stock is allowed to fall before we exit, and the lost opportunity of being in a stock that can move sideways for a considerable period.
Its one of the reasons I like to use the mack dee indicator, it largely moves us out of sideways moving stocks lacking momentum, whilst also taking us out of losing positions at a faster pace. The key is always to be in positive momentum, thereby getting our money working at its optimum rate of return. Not forgetting that by keeping drawdowns less, we can apply leverage to really improve returns.
The beauty of the Donchian strategy, is that it can be tailored to match the traders preference, for example, If we look again at the Netflix chart, but this time change the lower band to 4 weeks instead of 40, whilst keeping the upper band at 50 weeks, the channel, as we can see, becomes tighter.
We now revisit the entries and exits. We can see our first action would be to exit a trade just as the red candle closed below the 4-week low band. We then await a break above the 50-week high, which we see here at the close of the candle.
The next exit appears a few months later when this candle closed below the 4-week low.
We re-enter here at the cross above the 50 high, and exit a few weeks later when we get a cross down below the 4 week low.
For me the tighter setting suits my style of trading, I prefer less risk and accept that I may get whipsawed out of some positions more frequently. Nonetheless the 50 high and 40 low setting has proven to be a solid strategy over the last 30 years.
We can see here a breakdown of the annual results from 1991. From a drawdown perspective the results look solid, but as always the devil is often in the detail.
A breakdown of the data to a monthly level, shows that there are considerable drawdowns, despite the annual results being healthy. In 1998 for example the annual return was a positive 38.5%, yet there was a two-month period which declined over 26%. In 2000 a positive 13.4% annually, yet a 3-month period of a 26% drawdown. All the way through to 2020 where we had a positive 9% annual return yet a two-month period declining 25%. Using excessive leverage during these periods could cause major loss, despite what the annual analysis would suggest.
The Donchian system certainly has merit, but remember to choose the settings that feel more suited to your style and risk tolerance.
One of the key drawbacks when using the high and low bands in comparison to my preferred style, is how loose price action is allowed to be. For example this breakout of the high band, is preceded by considerable volatility, I prefer to see a contraction in price prior to breaking the high, this allows me to put a tight stop loss in place allowing for a favourable risk to reward.
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