The Donchian Rules

The influence of Richard Donchian in the managed future industry cannot be neglected. He is known as the father of mechanical trading systems, as well as the originator of the managed money industry. Despite his earlier effort to promote his modern approach of trading, it was only his mid-sixties when he started to gather fame and make a real fortune for himself. It is a remarkable example that when you set your mind on doing something, you can eventually do it.

Over his long years in the market, Donchian had developed an important list of rules to which every serious trader should pay attention. In 1934, he compiled his Twenty Trading Guides which serve as the cornerstones of his trading approach. In 1978, one of his student published his Guides in a magazine (Dixon, 1978):

General Guidelines (Eleven in Total):

1. Beware of acting immediately on a widespread public opinion. Even if correct, it will usually delay the move.
2. From a period of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume increases.
3. Limit losses and ride profits, irrespective of all other rules.
4. Light commitments are advisable when market position is not certain. Clearly defined moves are signaled frequently enough to make life interesting and concentration on these moves will prevent unprofitable whip-sawing.
5. Seldom take a position in the direction of an immediately preceding three-day move. Wait for a one-day reversal.
6. Judicious use of stop orders is a valuable aid to profitable trading. Stops may be used to protect profits, to limit losses, and from certain formations such as triangular foci to take positions. Stop orders are apt to be more valuable and less treacherous if used in proper relation to the chart formation.
7. In a market in which upswings are likely to equal or exceed downswings, heavier position should be taken for the upswings for percentage reasons a decline from 50 to 25 will net only 50 percent profit, whereas an advance from 25 to 50 will net 100 percent profit.
8. In taking a position, price orders are allowable. In closing a position, use market orders.
9. Buy strong-acting, strong-background commodities and sell weak ones, subject to all other rules.
10. Moves in which rails lead or participate strongly are usually more worth following than moves in which rails lag.
11. A study of the capitalization of a company, the degree of activity of an issue, and whether an issue is a lethargic truck horse or a spirited race horse is fully as important as a study of statistical reports.

Technical Guidelines (Nine in Total):

1. A move followed by a sideways range often precedes another move of almost equal extent in the same direction as the original move. Generally, when the second move from the sideways range has run its course, a counter move approaching the sideways range may be expected.
2. Reversal or resistance to a move is likely to be encountered: A. On reaching levels at which in the past, the commodity has fluctuated for a considerable length of time within a narrow range. B. On approaching highs or lows.
3. Watch for good buying or selling opportunities when trend lines are approached, especially on medium or dull volume. Be sure such a line has not been hugged or hit too frequently.
4. Watch for crawling along or repeated bumping of minor or major trend lines and prepare to see such trend lines broken.
5. Breaking of minor trend lines counter to the major trend gives most other important position taking signals. Positions can be taken or reversed on stop at such places.
6. Triangles of ether slope may mean either accumulation or distribution depending on other considerations, although triangles are usually broken on the flat side.
7. Watch for volume climax, especially after a long move.
8. Don’t count on gaps being closed unless you can distinguish between breakaway gaps, normal gaps, and exhaustion gaps.
9. 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.

Donchian considered the third rule in the General Section, as well the fourth, fifth and ninth rules in the Technical Section to be the most important. Overall, it is surprising that what was written by Donchian in 1934 is still relevant and useful one hundred years later.

REFERENCE: Dixon, B. S. (1978, October). Donchian’s Twenty Guides to Trading Commodities. Commodities, 44-45.