Donchian Breakout with Parabolic Exit

By José Cruset of Wealth-Lab 

©2005, Reprinted with permission of Active Trader magazine (www.activetradermag.com)

Market: Futures.

System Concept: Many trend-following systems use Donchian channels, which contain upper and lower boundaries to signal breakouts. The indicator’s upper channel represents the highest high of a specific look-back period, while the lower line is the lowest low over the same period.

Traders typically use the channels to trigger entry and exit signals as soon as price crosses above (or below) one of the lines, and the position is reversed once price penetrates the opposite line. For example, go long if price crosses above the upper channel line and then exit this trade and sell short if price then drops below the lower channel line.

This approach tends to perform well in trending markets, but the drawback is that the indicator lags price action — it neither catches the beginning of a trend nor exits at the precise end of one, which means a large portion of potential gains are lost.

This system uses a different exit method to prevent giving away too much (unrealized) profit. The look-back period for the Donchian channels is 40 days, or roughly two months. System entry rules are standard: As soon as price crosses above the upper channel line, it enters a long position with a stop; it sells short when price crosses below the lower channel line. While a trade is in progress, the exit channel’s look-back period drops by one each day until it reaches 10 days where it remains until the trade closes.

Because the channel line opposite the entry line serves as a stop level, it is also used as a position-sizing parameter for the existing position. When defining position size we always have the maximum loss in mind. Therefore, the further away the stop is, the smaller our position size. This exit rule ensures the opposite channel line will not move too far away from price and, hopefully, will prevent the trade from giving back too much of its prior gains.

Figure 1 shows a sample trade in the S&P E-Mini (ES), which began in early February 1998. After the E-Mini broke above its upper 40-day channel line (red), the system went long and held that position for more than two months.

At the beginning of the trade, the exit line (green) started with a 40-day look-back period and was far away from the entry price. However, the distance between the two lines began to shrink as the exit line’s look-back period shortened.

By April 27th, the exit line’s look-back period had been reduced to 10 days. The system exited, allowing it to hold on to some profits. At this point, the lower channel reestablished its 40-day lookback period, which explains its sharp decline. It took another month to establish a new (short) position.

Rules:

1. Enter long (with a stop) when price crosses
above the upper 40-day Donchian channel.
2. Enter short (with a stop) when price crosses
below the lower 40-day Donchian channel.
3. For long trades, reduce look-back period for
lower channel by one for every day that each
position is in the market. Exit long trade when
price crosses below lower Donchian channel.
4. For short trades, reduce look-back period for
upper channel by one for every day that trade is
in progress. Exit short trade when price crosses
above upper Donchian channel.

Starting equity: $1 million. Deduct $20 commission per roundtrip trade. Apply two ticks of slippage for each entry/exit.

Money Management: Risk a maximum of two percent of total account equity per trade. The number of contracts is calculated using the basis price, the initial stop-loss level, the contract’s point value (i.e., the dollar value of a one-point move), and the portfolio’s total equity. The basis price is the entry price of the new position. The initial stop-loss level is the lowest low or highest high of the last 40 days.

For example, assume the system goes long at $100, the contract has a point value of $250, and the stop level is $90. To find out the trade’s dollar risk, multiply the point value ($250) by the difference between the basis price and the risk-stop ($10, or $100 - $90). Therefore, a single contract’s risk is $2,500.

If the portfolio’s total equity before entering the position was $1 million and we did not want to risk more than two percent of our total equity ($20,000), we would buy eight contracts.

Had total equity been less than $125,000, we would not have been able to take this position because its dollar risk would exceed our system’s two-percent equity risk. This position-sizing method keeps us out of risky trades that have potential to ruin our account.

Test data: The system was tested on a new Active Trader Standard Futures Portfolio, which contains the following 20 futures: British pound (BN), soybean oil (BO), corn (C), crude oil (CL), cotton #2 (CT), Nasdaq E-Mini (EN), S&P E-Mini (ES), 5-year Tnotes (FB), Euro FX (FN), gold (GC), Japanese yen (JN), coffee (KC), wheat (KW), live cattle (LC), lean hogs (LH), natural gas (NG), sugar #1 (SB), silver (SI), Swiss franc (SN), and 30-year Tbonds (US). This test used ratio-adjusted data from Pinnacle Data Corp; symbols in parentheses represent Pinnacle symbols.

LEGEND: Net profit — Profit at end of test period, less commission • Exposure — The area of the equity curve exposed to long or short positions, as opposed to cash • Profit factor — Gross profit divided by gross loss • Payoff ratio — Average profit of winning trades divided by average loss of losing trades • Recovery factor — Net profit divided by max. drawdown • Max. DD (%) — Largest percentage decline in equity • Longest flat days — Longest period, in days, the system is between two equity highs • No. trades — Number of trades generated by the system • Win/Loss (%) — The percentage of trades that were profitable • Avg. trade — The average profit/loss for all trades • Avg. winner — The average profit for winning trades • Avg. loser — The average loss for losing trades • Avg. hold time — The average holding period for all trades • Avg. hold time (winners) — The average holding time for winning trades • Avg. hold time (losers) — The average holding time for losing trades • Max. consec. win/loss — The maximum number of consecutive winning and losing trades

LEGEND: Avg. return — The average percentage for the period • Sharpe ratio — Average return divided by standard deviation of returns (annualized) • Best return — Best return for the period • Worst return — Worst return for the period • Percentage profitable periods — The percentage of periods that were profitable • Max. consec. profitable — The largest number of consecutive profitable periods • Max. consec. unprofitable — The largest number of consecutive unprofitable periods

Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see tested, please send the trading and money-management rules to editorial@activetradermag.com.

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.

Test Period: January 1995 through January 2005.

Test results: Most trend-following systems tend to have a low percentage of winning trades and a high profit per winning trade. Therefore, a small number of trades typically drive these systems’ profits. However, this system is different: It has a balanced win/loss ratio (e.g., 45.6 percent), and winning trades have an average profit of only 6.09 percent. Still, its average yearly return is 10.33 percent.

The system’s equity curve (Figure 2) and yearly results (Figure 4) both show a nice increase during the first five years (1995 to 1998) as well as the last three years (2002 to 2004). However, it lost ground in 1999 and 2000, and had a period of 858 days between equity highs during this time.

Figure 3 also shows that the system’s 36-percent maximum drawdown occurred in this period. Most traders probably don’t have the patience to continue trading this system through such a long, flat period and high drawdowns.

Also, the system’s low per-trade average profit (0.26 percent) leaves it vulnerable to commissions and slippage. When trading this system in real market conditions, slippage might be larger than two ticks (used here) and could wipe out this system’s profitability.

To determine the effect of the modified exit-rule, we compared the results with those of a fixed, 40-day Donchian breakout system for both entries and exits. (The fixed system was also stop-and-reverse [SAR], meaning it was always in the market.)

Although the stop-and-reverse system had a higher exposure (24.23 percent vs. 17.02 percent), Figure 5 shows that its yearly returns were significantly worse. In addition, its average per-year return fell to 8.38 percent (from 10.33 percent), its longest flat period grew to 948 days (from 858), and its maximum drawdown rose to 38.03 percent (from 36.06 percent).

Bottom line: A Donchian channel-based breakout system with a modified exit rule is better than one with the standard, fixedperiod exit rule. As you move the exit line closer to price, the system tends to exit each trade earlier and retain a larger portion of a trade’s unrealized gain.