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Richard Donchian - Market Master
Neil A Costa
Richard Davoud Donchian was born in Hartford, Connecticut in September 1905. His parents had migrated to the United States from the Armenian province of Turkey in the 1880s. Young Richard went to school in Connecticut, later graduating from Yale University with a Bachelor of Arts degree in economics. Upon graduation he worked in his family’s Oriental rug business.
After reading Reminiscences of a Stock Operator, Donchian’s interest turned to the markets. He lost money during the crash of 1929, which led him to study technical analysis.
He began his Wall Street career in 1930. He published a stock market service called ‘Security Pilot’ which he sold to brokerage houses. In 1933 he became an account executive and securities analyst with Hemphill, Noyes and Co., while remaining in the position of Vice President of the Samuel Rug Company.
During World War II, Richard Donchian took part in the invasion of Sicily and later became an Air Force statistical officer. After the War he became a private investment adviser and securities analyst. He was self-employed until 1960. In 1948 Donchian changed his focus from securities analysis to trading. He established Futures, Inc., one of the first publicly held commodity funds.
Donchian developed the trading approach which became know as “trend following”. It was based on the assumption that commodity prices moved in long, sustained moves. Donchian developed and used a trading system based on moving averages. He wrote many articles on futures trading and securities and became known as ‘the father of trend following’.
In 1960 he was appointed Director of Commodity Research with Hayden Stone Inc. He commenced writing a weekly newsletter Commodity Trend Timing based on his 5-20 moving average method. His newsletter reached a weekly circulation of some 10,000 copies and he wrote it for 19 years. He wrote numerous articles including ‘Trend Following Methods in Commodity Price Analysis’. He later joined Shearson Lehman Smith Barney, eventually becoming Vice President.
Richard Donchian was best known for his original work in commodities futures money management. During his career he was a member of several exchanges, such as the New York Cotton Exchange, and several professional associations, such as the New York Society of Security Analysts.
Donchain’s legacy lives on. Many modern trend following systems, such as the Turtles’ system (www.originalturtles.com), is based on his work. The Richard Davoud Donchian Foundation was established after his death in April 1993. Its aim is to help others achieve high levels of personal and professional success.
Donchian’s Methods
Donchian’s Trading Guides
Richard Donchian documented his trading guides in 1934. He reviewed them in 1974, noting the ones he felt were the more important, some 40 years after they were first documented. The more important rules are reproduced in bold type.
General Rules: - Beware of acting immediately on widespread public opinion. Even if it is correct, it will usually delay the move.
- From a period of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume decreases.
- Limit losses and ride profits, irrespective of all other rules.
- Light commitments are advisable when a market position is not certain. Clearly defined moves are signalled frequently enough to make life interesting, and concentration on these moves to the virtual exclusion of others will prevent unprofitable whipsawing.
- Seldom take a position in the direction of an immediately proceeding three-day move. Wait for a one-day reversal.
- Judicious use of stop orders is a valuable aid to profitable trading. Stops may be used to protect profits, limit losses and take positions from certain formations such as triangular foci. Stop orders are apt to be more valuable and less treacherous if used in proper relation to the chart formation.
- In a market where upswings are likely to equal or exceed downswings, a heavier position should be taken for the upswings for percentage reasons; a decline from 50 to 25 will net only 50% profit, whereas an advance from 25 to 50 will net 100%.
- In taking a position, price orders are allowable. In closing a position, use “market” orders.
- Buy strong-acting, strong-background commodities and sell weak ones subject to all other rules.
- Moves in which rails lead or participate strongly are usually worth following more than moves in which rails lag.
- A study of the capitalization of a company, the degree of activity of an issue and whether the issue is a lethargic truck horse like Consolidated Edison or a spirited, volatile race horse like Case Threshing Machine is fully as important as a study of statistical reports.
Technical Guides: - A move followed by a sideways range often proceeds another move of almost equal extent in the same direction of the original move. Generally, when the second move from the sideways range has run its course, a countermove approaching the sideways range may be expected.
- Reversal or resistance to a move is likely to be encountered on reaching levels at which the commodity has fluctuated for a considerable length of time within a narrow range in the past or on approaching previous highs or lows.
- Watch for good buying or selling opportunities when trendlines are approached, especially on medium or dull volume. Be sure such a line has not been adhered to or hit too frequently.
- Watch for “crawling along” or repeated bumping of minor or major trendlines and prepare to see such trendlines broken.
- Breaking of minor trendlines counter to the major trend gives most other important position-taking signals. Positions can be taken or reversed on stop at such places.
- Triangles of either slope may mean either accumulation or distribution depending on other considerations, although triangles are usually broken on the flat side.
- Watch for volume climax, especially after a long move.
- Don’t count on gaps being closed unless you can distinguish among breakaway gaps, normal gaps and exhaustion gaps.
- During a move, take or increase positions in the direction of the move at the market the morning following any one-day reversal, however slight the reversal may be, especially if volume declines on the reversal.
Figure 1 - A Gann Analyst Chart of BHP Billiton Limited Showing Seven Entry Points Using the Crossing of Minor Trend Lines. (Technical Guide 5: Breaking of minor trendlines counter to the major trend gives most other important position-taking signals. Positions can be taken or reversed on stop at such places.)
Donchian’s Four-Week Rule
Donchian’s four-week rule forms the basis of many modern trading systems. The best known of these is the Turtles trading system.
His rules were surprisingly simple: - Go long (and cover shorts) when the current price exceeds the highs of the previous four full calendar weeks.
- Go short (and liquidate longs) when the current price falls below the lows of the previous four full calendar weeks.
- Roll forward if necessary into the next contract on the last day of the month preceding expiration.
(Kaufman, P., The New Commodity Trading Systems and Methods, John Wiley and Sons, New York, 1987, page 212.)
Donchian’s 5- and 20-Day Moving Average System
Many traders have used Donchian’s 5- and 20-day moving averages since 1961. It is not known why he chose these two values, however they do relate to the number of trading days in a week and a month, respectively.
Donchian’s idea is to use a volatility-penetration criterion relative to the 20-day moving average, but with some added complication. The current penetration must not only cross the 20-day moving average but also exceed any previous 1-day penetration of a closing price by at least one volatility measure.
The 5-day moving average serves as a liquidation criterion (along with others) and is also modified by prior penetration and volatility. These features tend to make Donchian’s volatility measurement “self-adjusting”…
(Kaufman, P., The New Commodity Trading Systems and Methods, John Wiley and Sons, New York, 1987, page 86.)
Donchian Channels
Channels are usually curved lines that contain the price action. Plotting a moving average, then plotting the channel lines by “moving” the moving average vertically up and vertically down by a fixed percentage of the price, typically produces these.
Plotting the highest close and the lowest close, for the last “n” periods created Donchian’s channels. These two lines form the upper and lower boundaries of the channel. A middle channel line is plotted – this is the mid point between the highest and lowest closes.
Donchian traded the long side of the market if the channel pointed upwards, buying on a retracement to the lower side. He traded the short side of the market if the channel pointed downwards, selling on rallies to the upper side of the channel or to the mid point line.
Conclusion
Richard Donchian was a true pioneer of technical analysis. The fact that the trading methods he developed form the basis of so many trading methods used today is an excellent indication of the value of his discoveries.
Richard Davoud Donchian was a true market master.
neil@marketmasters.com.au
(This article was first published in the ATAA Journal, May/June 2004. Reprinted with permission.)
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