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What is Donchian Channel Breakout Trading System?

The Donchian Channel Breakout Trading System is a simple trend following mechanical trading system which gives the entry and exit.

The trading system is extremely simple and easy to use and removes emotions from trading.

The trading or investing logic is simple.... buy on close above 20 days high and sell on close below 20 days low.

No target is given as profits are unknown and is whatever the market gives. Losses are limited via position sizing.

Caveat: this indicator works best with indices and highly liquid stocks. It is not recommended for stocks with poor liquidity
(for that matter, any indicator).

Basic logic/ concept

When any stock has to rally, it has to cross some levels. This can be prior resistance, last week or month highs etc. Here I have chosen 20 days high as the reference level. Why 20 days? Because there are 20 trading day in a month.

For fewer and longer signals, you can also choose say quarterly breakout by using 60 days as reference level. For fast trades and profits (and more whipsaws), you can choose weekly breakouts i.e. 5 days.

A feature of markets all traders must understand... a market is either trending or range bound. Some traders look at a trend as nothing but a series of range breakouts. Now a stock will show fantastic move only when there is a breakout from a range.

Probability and trading outcomes

The outcome of any trade is random. This means for a large number of trades, there will be a uniform distribution of trades giving small profits, small losses, big profits and big losses.

The trades with small profits and losses will cancel each other and you are left with trades with big profits and big losses.

So how do you make money? You can make money only by (a) cutting losses fast and (b) let profit making trades continue as long as possible.

Risk management / Position sizing

Losses are inevitable in trading. As a trader, your primary objective is loss minimization (and not profit maximization).

Risk management defines your maximum loss in any trade. My personal experience is you should limit your maximum loss per trade is under 1% of your trading capital.

Quantity to buy = (1% of trading capital) / (Purchase Price Ė Stop loss)

Further, do NOT invest more than 5% of your capital in any single trade.

About whipsaws

All indicators give whipsaws and the Donchian Channel Breakout Trading System is no exception. But it is easy to know when a signal is likely to generate a whipsaw.

The first warning will be where the stock is trading in a small range for a long time. Here it is possible to get a buy signal today followed by a sell signal in next few days.

The second is where a buy signal is generated near a known/ significant resistance. When you get a whipsaw or 2 loss making trades for the same stock, then it makes sense to ignore further signals until the stock breaks out from the range.

Another way to identify range bound stocks is to just see the price movement over last 5-6 months... if the stock has not gained or lost much then it means it is directionless and hence range bound.

Same for the sell side.

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