Donchian channels are used to show volatility, breakouts, and potential overbought/oversold conditions for a security. The Donchian system uses adjustable bands that are set equal to the n-period's highest highs and lowest lows across a moving average. The upper and lower bounds of a Donchian channel can also form effective support and resistance levels, particularly when used in combination with other technical indicators.
Most Donchian trading systems use a four- or five-week moving average line. Basic Donchian channel analysis waits to spot the point where a security's price breaks through the upper or lower band, at which point the trader enters into a long or short position. For example, when the price exceeds the high of the previous four weeks, most go long and cover their short positions.
Donchian channels also make natural partners with another moving average indicator for a crossover strategy. The Donchian moving average middle line is likely to form the short-term average in these situations, although some have used a 20-day Donchian channel in conjunction with a five- or 10-day channel to exit a position before a consolidation eats into short-term profits.
The danger of incorporating Donchian channels into a trading strategy lies in their simplicity. It is very easy to spot a breakout from the upper or lower bounds, but these events are uninformative on their own. For example, a breakout might indicate the start of a long-term trend, or it may trigger a possible reversal. Donchian channels don't provide new information; they only allow the trader to visualize information that could easily be obtained other ways. They are best used as confirmation tools along with other tools of analysis.