At face value, Donchian Channels looks a lot like a Bollinger Bands and may be perceived as operating identically to it. While Bollinger Bands are useful trading indicators that are widely known and used by traders in all types of security markets (such as – stocks, Forex, and cryptocurrencies), Donchian Channels can offer comparatively more reliable trading opportunities depending on the trading scenario and your trading strategy. But is one indicator better than the other?
It depends on the nature of the market one is trading in, the asset and its volatility, the trading strategy, and the risk tolerance of the trader. In cases where the market volatility is high and/or the trader has moderate to high-risk tolerance, Bollinger Bands will prove to be a better trading indicator.
Bollinger Bands are dynamic, react faster, and are agile to use for high volatility assets.
But the opposite is also true: there are situations where you should choose Donchian Channels over Bollinger Bands. So, which situations should you be more inclined to use one as opposed to the other? In the remainder of this article, alongside discussing the key similarities and differences between the two indicators, we’ll discuss those conditions in detail.
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Similarities and Differences Between Donchian Channels and Bollinger Bands
Before deciding which indicator is best suited for your market, trading asset, and trading strategy, it is vital to first understand the key similarities and the key differences between the two indicators.
Therefore, let us identify the key areas of similarities and differences between the two indicators.
Similarities Between Donchian Channels and Bollinger Bands
There are three main similarities between the Donchian Channels and the Bollinger Bands. These are:
- Indicator Appearance
- Volatility Measurement
- Indicator’s Response to Volatility Changes
Now, let us further expand on these three areas of similarities in a bit more detail.
Similarity-1: Indicator Appearance
Indicator Appearance is the most noticeable commonality between the Donchian Channels and the Bollinger Bands. Both Indicators comprise of three bands – the upper, the lower and the middle band. Hence, to the eyes of a novice trader, both these indicators look exactly the same.
Similarity-2: Volatility Measurement
Both indicators, Donchian Channels and Bollinger Bands, measure the volatility of the security market that is being analyzed. A trading security is considered volatile when it records rapid fluctuations in price. Similarly, a trading security with less fluctuations in its price is considered to be less volatile.
Similarity-3: Indicator Response to Volatility Changes
With both indicators, an expansion would indicate an increase in volatility and a contraction would suggest the opposite, a decrease in volatility.
Therefore, a Donchian Channel will expand when the security market becomes more volatile and contract in the opposite case. Likewise, the upper and lower Bollinger Bands will either expand outward from the middle band or contract closer based on whether volatility is increasing or decreasing, respectively.
Differences Between Donchian Channel and Bollinger Bands
The main difference between the Donchian Channels and Bollinger Bands is that Donchian Channels represent volatility using high and low prices. In contrast, Bollinger Bands rely on the standard deviation from the mean. This means that, where Bollinger Bands will smooth out the range to account for outliers, a Donchian Channel will not and could potentially give an interpretation of the market volatility that is affected by the outliers (unusual fluctuations in price) and not be as accurate.
Additionally, Bollinger bands show the dispersion from the mean (the average of the price for a given period), whereas the Donchian Channel shows the actual market range.
That being said, there are three key differences between the Donchian Channel and the Bollinger Bands. These are –
- Indicator Calculations
- Relationship between Indicator Bands
- Breakout Interpretation
Now, let us further expand on these three areas of differences between these two indicators.
Difference-1: Indicator Calculations
The Donchian Channels record the highest highs and the lowest lows of a price over a given period. But Bollinger bands plot the difference of two standard deviations (under default indicator setting) from the simple moving average of the price data for the period. This means Bollinger Bands make provisions to account for outliers and prevent them from skewing the data analysis.
Difference-2: Relationship between Indicator Bands
The upper and lower lines (or bands) in a Bollinger Bands indicator are calculated using the middle line of that indicator:
Upper Channel = Middle Channel + 2 Standard Deviations
Lower Channel = Middle Channel – 2 Standard Deviations
The opposite is true for the Donchian Channels indicator in which the middle line is rather calculated by taking an average of the upper and lower lines:
Middle Channel = (Upper Channel – Lower Channel) / 2
Difference-3: Breakout Interpretation
When price breaks outside of the upper or the lower channel, it has different interpretations for trading using the two indicators.
In the case of Bollinger Bands, a breakout outside the upper or the lower band indicates a potential reversal in trend. A breakout in the price above the upper band of Bollinger Bands suggests that perhaps the market has been overbought and is due to bounce back. Likewise, when the price of the asset breaks below the lower band of the Bollinger Bands, it indicates that prices have fallen too much and are due to bounce back.
But, the same is not true for the Donchian Channel. In the case of Donchian Channel, a breakout is indicative that the price has broken out of its recent trading range and a new trend may be developing. If the price of the asset breaks above the upper band of the Donchian Channel, you go long because an uptrend could be developing. Again, if the price breaks below the lower band of a Donchian Channel, a downtrend could be developing, so you go short.
When Should You Choose Bollinger Bands Over Donchian Channel?
When it comes to application in trading, both Bollinger Bands and Donchian Channels have their own strengths. There are three trading scenarios in which Bollinger Bands will give you better results than the Donchian Channel. These are:
- Early Trade Entry and Exit Signals
- Trading High Volatility Assets
- Higher Number of Trading Opportunities
Now, let us discuss each of these three scenarios in a bit more detail.
Scenario-1: Early Trade Entry and Exit Signals
Bollinger Bands will position you better than the Donchian Channels in making early trade entries. This is because this indicator reacts quicker to the changing market, thereby providing traders with an early trade signal. For this very reason, Bollinger bands are also better suited for tracking markets that have rapidly changing trends. The moving average used in Bollinger Bands provides further support in determining the trade entry and exit points.
Scenario-2: Trading High Volatility Assets
Bollinger Bands will also prove to be a better indicator of choice when trading high volatility assets. Donchian Channels do not include the current price of an asset in their calculation to produce the upper, lower, and middle bands, but instead, rely on the previous rates of the asset in the market. This can be detrimental to trading a highly volatile asset because the most recent price is an important indicator in such markets.
Besides this, Donchian Channels are not inherently designed to deal with highly volatile assets. Their creator, Richard Donchian, was a conservative trader, and he did not create this indicator with the intension of using it for analyzing highly volatile assets. Bollinger Bands, however, are well equipped to do so and are dynamic in being able to adjust to highly volatile asset markets.
Scenario-3: Higher Number of Trading Opportunities & Dynamic Trade
If you are an active trader or a scalper looking to profit from every trading opportunity that the market presents, Bollinger Bands would better suite your trading personality. Since this indicator reacts quickly to the price changes in the market, it tends to provide more trading opportunities.
When Should You Choose Donchian Channels Over Bollinger Bands?
Bollinger Bands have many advantages over Donchian Channels, but there are several situations under which the Donchian Channels can prove to be a superior indicator. The two trading scenarios under which the Donchian Channels will deliver better trading results than Bollinger Bands are –
- Risk-Averse Trading
- Trading Choppy Markets
Now, let us cover both these market conditions in a bit more detail.
Scenario-1: Risk-Averse Trading
Donchian Channels are the ideal choice for the risk-averse trader. Bollinger Bands are dynamic indicators that react quickly to the changing market conditions. Hence, Bollinger Bands inherently come with more risk. In scenarios where your risk appetite as a trader is low, Donchian Channels will be better suited for your trading psychology.
Scenario-2: Trading Choppy Markets
Even though Bollinger Bands allow for early entry, but they are also more likely to give a false trade signal in scenarios where the price fluctuations are short-lived. Therefore, if you are trading in a market that is “choppy” or a market that does not have a clear direction, the possibility of getting a false trading signal with using Bollinger Bands is very high. Hence, I would recommend against using Bollinger Bands in such trading conditions.
In such trading scenarios, Donchian Channel will give you much better insights that will help you isolate the major trends from sideways market movement. Hence, for that reason, Donchian Channel is a better indicator to use when trading choppy markets.
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To recap, the Donchian Channel and Bollinger Bands are both chart indicators that are commonly used by technical traders to make trading decisions. These indicators exhibit several similarities but are very different from one another. Deciding which of the two indicators is better suited for your specific trading needs will depend on many different factors such as your trading strategy, the asset you wish to trade, and the nature of that asset’s market.
It is also important to note that no indicator should be used in isolation to analyze the market. Instead, any indicator should only be a cog in the overall wheel of your trading strategy.
For optimum results, it is important that you combine various chart indicators with other complementary tools/analyses, and use the collective insights from that combination in making your final trading decisions.
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