Trade the Trend with This Strategy

11/25/2009 12:04 am EST

Focus: STRATEGIES

Richard Donchian’s four-week rule was built on the belief that traders should buy things that are making new highs. When price makes new lows, that may be the time to protect profits or cut losses. Donchian’s four-week rule was quite simple actually. Traders would buy on a new 20-day high and sell or short if price made a new 20-day low. Why 20 days? For traders using daily charts, four weeks contain 20 trading days, not including holidays.

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Price Range Donchian Channel

Donchain’s rules were used to create the Donchian Channel Indicator, which is placed on top of a price chart. The upper channel line represents the high over the past 20 trading days. The bottom line represents the low over 20 days. During periods of greater volatility, the lines would be further apart. When price stayed in a tight consolidation channel, the upper and lower lines can illustrate price compression.

When Do Donchian Channels Work Best?

Like any trend-following indicator, when markets are trending, indicators work best. During sideways or choppy markets, traders tend to get whipsawed, seeing a series of small losses and small gains. The idea is that trend traders never know what trades will wind up being large winners, but since positions are exited before they turn into large losses, the result is the large winning trades taking care of the collection of smaller losses.

By Derek Moore of TradeSurfer.com

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