TRADERS´ BASICS 59 Adaptive and Optimised Donchian Channels Monest Channels Channels are at the heart and soul of technical analysis, from as early as its conception. However, up to this day, they come with a lot of subjectivity. This implies that it is hard to implement them algorithmically. Yet, computers and automation might have been the single most important driver in the wide spread adoption of the technical analysis discipline. This article will show how to objectify and optimise the calculation of horizontal channels and, hence, the support and resistance lines they are made up of. 08/2011 www.tradersonline-mag.com TRADERS´ BASICS 60 Ranges Rock for a resistance line. Figure 1 Ranges are quite important in shows an upper Donchian channel the analysis of charts and the line (resistance) with a look back automation of it. They give birth period of 36 days and a lower to the timecompression needed Donchian channel line (support) for new trends to develop and with a window of 20 days. When for existing trends to turn. Even you go back in time, starting at the the most well known systems right side of the chart, the highest like William O’Neil’s CANSLIM high over the past 36 days was approach, Weinstein’s stage 3.29, while the lowest low over analysis and a lot of trend the past 20 days was 2.26. These following strategies depend lines are annotated on the chart as on them to make decisions D36 and D20. concerning the possible start Perhaps, by now, you already of a trend, phase or stage. noticed the fact that the most Consolidation, also known as recent bar is not included to a base, from where an existing calculate the highest high or the trend continues its run, is another lowest low, because that would example where ranges emerge. mean that our channel lines The detection of ranges is never could be violated, as, for Dirk Van Dycke where horizontal channels come instance, a higher high for the into the picture. One of the oldest current bar than the highest high Dirk Van Dycke is actively and and perhaps most popular ways over the look back period, would F1) Donchian Channels independently studying the of describing horizontal channels implicate that our current high markets since 1995 with a focus is by using the definition provided would be the upper Donchian on technical analysis, market to us by Richard Davoud channel, by definition. Idem ditto dynamics and behavioral finance. Donchian (†). for lower Donchian channel lines. He writes articles on a regular Furthermore, one could basis and develops software Donchian Channels redefine Donchian lines using the partly available at his website Perhaps Donchian’s channels, close. Our D20 from the example, tools.monest.net. Holding master named after himself, are even by this definition, would then degrees in both Electronics Engi- better known as an x-bar become the lowest close over neering and Computer Science, high/low. But they are merely de past 20 bars, while our D36 he teaches software develop- the implementation of the would stand for the highest close ment and statistics at a Belgian mathematical minimum (min) over the past 36 days. University. He’s also an avid and maximum (max) functions. There is really not much to all reader of anything he can get his What these channels stand for, is Donchian Channels are amongst the oldest and most basic channels this. In fact, Donchian channels in technical analysis. They are also known as x-bar high/low channels. hands on. He can be reached at basically the looking back over a are so simple, one might think But they are not completely objectively defined as, in this example, a 36 day upper Donchian Channel can be replaced with a 100 day upper [email protected]. certain period and calculate the there is nothing to add at this Donchian Channel at the same price. lowest low in this interval, for a point. These channels should Source: tools.monest.net support line, or the highest high do be able to help us detect 08/2011 www.tradersonline-mag.com TRADERS´ BASICS 61 horizontal channels in an fully see they are totally objective in price representing the vertical price already moved substantially longer the maximum Donchian automated way. But they do not. both their definition and their dimension. We need to stop before reaching one of the Channels line gets as we increase implementation, since they do not thinking of horizontal channels channel lines, giving late warning or decrease its height by the Not so Fast need any parameters and they as having only one dimension, as to any outbreak. A too short a smallest increment possible (i.e. The truth is, there is a lot of adapt themselves to the context we probably get tricked into this channel is not meaningful as a tick – being most often one subjectivity left with Donchian of price, time and volatility. exactly because of the horizontal the longer a channel gets the cent). So to calculate the upper channels, as with many indicators What are they all about? nature of the separate channel more people come to recognise Monest Channel line we start by in technical analysis. The Looking at Figure 1 again, you lines. A horizontal line may not it and use it and thus the more measuring the length that prices question hereby arises what the can see that D36 is the same line have a height in itself, it sure has meaningful it becomes as an stay lower or equal to our most look-back-period should be. Do as D100. What this means is that a vertical coordinate on a chart, analysis instrument. So, how can recent close. Next we calculate we take a 50 bar high or a 60 bar our highest high over the past 36 which makes for a width of the we have both maximum length the same length for a price one high? Answering this question days, happens to and minimum width, or, cent higher. The extra length based on back test results, be the same highest as that is not possible, we get is the first derivative at imposes the danger of curve- high over the past a optimal trade-off? those price levels. It basically fitting on your system. 37 days. But also This sounds a lot more comes down to how much bars Secondly, they are static, the same highest Implementation our channel line gets longer if we meaning they do not account for high over the past complex than it really is. The answer to this widen our channel with one cent any context adaption, such as 38 days. In fact, we question is given to us to the upside. The same goes absolute versus relative prices have to go back, up by classic high school for the lower Monest Channel or, to a lesser degree, volatility. to a 100 days, before we find yet channel as the difference between math to solve max/min problems line while decrementing each A channel that is $10 in width in a new higher high. So if we would the heights of both channel lines through the use of derivatives. time with one cent. By doing a $10 stock has not the same have arbitrarily chosen a look the channel is made up of. There is one problem though, this incrementally for every cent, importance as the same $10 back period of 36 or higher but Secondly there are opposing we do not know the function we can get the optimum as the channel in an $100 stock. Even if anywhere less than 100, we would forces at work, since the wider describing a price chart and, as biggest increase in length we you would think about expressing not have optimal usage of our we make a channel, i.e. the range a consequence, neither do we gain for any cent we widened the channel-width in percentage channels when interpreting them of historical prices it captures, the know the functional description channel line during the iteration. to stock price, this would not without a chart. For a 36 day look longer its channel lines will get. of the relationship between width Figure 2 shows the length we account for volatility. Defining back period we could have gotten Look at it this way; if you expand and height of any channels. can go back without encountering width in terms of volatility (like an extra 64 days in length, without the lines enough, eventually all We will probably never know. prices for each distance form the ATR units) would be far better. widening the channels. historical prices will lie between Luckily, there is a simple trick last close. So on the x-axis is the Still, the issue about adaptivity So let us go over this again them. Length and width of any to circumvent this problem as distance form the latest close. and subjectivity stands, because for a moment as we outline a channel are, as a matter of fact, we can use discrete derivatives. The y-axis gives us the length at of the look back period that has few important thoughts. First functional interdependent of Now, don‘t you stop reading. This that distance. Both Monest bands to be chosen arbitrarily and up of all, we need to stop focusing each other. Length is inversely sounds a lot more complex than are shown in the same figure for front. So which look back period merely on the look back window reciprocal to width.