Breakout Trading using the Donchian Channel strategy

Summary

This video explains Richard Donan's Channel Breakout System, a trend-following method that emphasizes price action over fundamentals. The system uses a three-band indicator to identify breakout opportunities and includes rules for stock selection, entry, and exit. It has shown impressive returns since 1990, with an average profit of 62% per trade. However, the system also has its risks, with significant drawdowns during certain periods. The video highlights the importance of adjusting the system to fit individual risk tolerance and trading preferences, and it encourages viewers to join the author's group for further insights and strategies.

Takeaways

• 😀 Richard Donan developed the Donian channel breakout system, focusing on price action rather than fundamentals, which became a foundation for trend following strategies.
• 😀 Donan’s approach emphasizes making money from the markets rather than aiming for academic excellence in reading balance sheets.
• 😀 The Donan system gained popularity through the Turtle Trading strategy, which was based on his method and has seen substantial success.
• 😀 A simplified version of Donan's system has yielded over 5,000% return since 1990 with an average profit of 62% per trade and an average loss of 12%.
• 😀 The Donan channel uses three bands: upper, lower, and mid-range, based on a specific period (defaulted to 20 days) to identify breakouts and retracements.
• 😀 Breakout trades occur when a stock closes above the upper band or below the lower band, signaling a potential entry or exit point for traders.
• 😀 The strategy requires focusing on stocks from the Russell 1000 index, ensuring liquidity and reducing market risks.
• 😀 Key entry rules: Stocks must be above the 50-week high, and trades are entered when the stock closes above the 50-week high band, with exits occurring when the price drops below the 40-week low band.
• 😀 A tighter setting with 4-week lows and 50-week highs can be used for lower risk but may result in more frequent exits and fewer trades.
• 😀 Despite solid long-term returns, the system can experience significant drawdowns, with some periods seeing up to a 26% decline, which should be managed carefully, especially when leveraging.
• 😀 A contraction in price action before breaking the high band is preferred for tighter stop losses, improving the risk-to-reward ratio and better controlling volatility.

Q & A

What is the Donian Channel breakout system?

The Donian Channel breakout system is a trend-following strategy developed by Richard Donan. It uses price action to determine trade entry and exit points, focusing on the highs and lows of a specific period (usually 20 days) to create upper, middle, and lower bands. Breakouts beyond these bands signal potential trend continuation.

How does the Donian Channel system identify trade opportunities?

The system identifies trade opportunities by observing price breakouts. A long trade is triggered when the price breaks above the upper band, while a short trade occurs when the price falls below the lower band. The system uses a 20-day period by default to calculate these bands.

What performance results have been achieved using the Donian system?

Since 1990, the Donian system has yielded a return of over 5,000%. The average profit per trade was over 62%, with an average loss of under 12%. The win rate was just under 49%, demonstrating a solid yet balanced approach to trading.

What rules govern entry and exit for trades using the Donian system?

Entry occurs when a stock breaks above the 50-week high (upper band), and exit happens when the price closes below the 40-week low (lower band). Position sizes are set at 5%, with a maximum of 20 positions in the portfolio. If there are more qualifying stocks, the highest gainers are prioritized.

How does the Donian system handle market crashes or downturns?

The system aims to avoid major market crashes by using the 100-day moving average to confirm momentum. It only selects stocks from the Russell 1000 index, ensuring high liquidity. The exit rule, where trades are closed when prices fall below the lower band, also helps limit exposure during downturns.

Why might a trader adjust the parameters of the Donian Channel system?

Traders may adjust the parameters (e.g., using a shorter period for the lower band) to tailor the system to their risk tolerance and trading style. A tighter setting might reduce risk but could result in more frequent whipsaws, while a wider setting can allow for longer trends with fewer exits.

What is the role of the MACD indicator in modifying the Donian strategy?

The MACD indicator can be used alongside the Donian system to reduce risk during sideways market conditions. It helps traders avoid staying in positions that lack momentum and also facilitates quicker exits from losing trades, ensuring the portfolio stays aligned with positive momentum.

How does the use of leverage affect the results of the Donian system?

Leverage can amplify returns but also magnifies risks, especially during periods of significant drawdown. Although the system has performed well historically, the risk of using excessive leverage during downturns could lead to substantial losses, as seen during the drawdowns in the late 1990s and 2000s.

What are the potential drawbacks of the Donian Channel breakout system?

One drawback is the potential for large drawdowns during periods of high volatility, despite positive annual returns. Additionally, the system allows for considerable price movement before exits, which can be a concern for traders seeking tighter risk management.

What is the significance of the Russell 1000 index in the Donian Channel system?

The Russell 1000 index consists of the 1,000 largest U.S. stocks, ensuring high liquidity for the system's trades. By limiting trades to this index, the system avoids smaller, less liquid stocks that may have higher slippage and less reliable price action.