Let’s assume you are not filled on the first day. On the next day, you go back 20 days and again identify the high and low for that period. Most days, the 20-day high and low will not change. You do this every day to define a new 20-day high price and a 20-day low price. Every day, you would put in a new buy order just above the new 20-day high and a sell order just below the new 20-day low.
Eventually, you will be filled on either the long or the short side. Your initial stop is the entry order on the other side of the channel. For example, you are trading EUR/USD and the 20-day high is 1.50 and the 20-day low
is 1.40. I like to buy three pips above the breakout level. So in this case, you enter an order to buy at 1.5003 and an order to sell at 1.3997. The price trades up to 1.5003 and you are filled on the long side. Your original stop loss is 1.3997, which means that the original sell order now acts as your stop loss. You don’t have to do anything. Just leave that original sell order with your broker.
Once you are filled on the long side, in this example, place a new order to sell at 1.3997. Now you will have two orders to sell at 1.3997. You need to do this because the first order there will exit the long position but you need the second order to get you short. Classic channel breakouts are always in the market, either long or short.
Let’s look at Figure 3.1 to bring this to life. I’ve selected this chart because it shows both trending and nontrending markets. It shows both typical winning and losing trades.
The chart shows the British Pound from March through November. I’ve put a 20-day channel on the chart. Remember, the 20-day channel on any given day is simply the highest and lowest price for the previous 20 days. At the end of every day, you will put in orders to buy slightly above the 20-day high and sell slightly below the 20-day low.
Early in April, the Pound dropped below the 20-day low, thus triggering a sell signal getting us short on the Pound. We already have in an order to buy above the 20-day high but we add another similar order to make sure that we get long if the Pound rises above the 20-day high. Remember, we are always in the market using the classic channel breakout technique. So if the price traded up to above the 20-day high, we would get stopped out on our short position but also go long. That means that we need to have two buy orders above the 20-day high.
The market continued down over the next week and our trade looked good. Note that our stop at the 20-day high doesn’t change for almost two weeks. That’s because the highest price for each of those days didn’t
change. However, in mid-May, the top line representing the 20-day high finally started to drift lower. You would lower the protective stop and the long buy order each time that the 20-day high moves lower.
The Pound then drifted sideways through the end of April but broke down again in early May. The price of the Pound started to rally in mid-May. It rallied almost up to the top line of the channel but never surmounted
it. The Pound then dipped down to the 20-day low in mid-June. That dip was followed by a rally that eventually caused a break of the 20-day high line near the end of June. You would be stopped out of the previous short position and would also get long. You would have lost about 250 pips on the short position and be long with a stop at the 20-day low line.
We get a few days of follow-through but the market then turns lower into early July. The market then hits a new high in mid-July and we are thinking we are genius traders. We also are raising our stop just about every
day during this time as the 20-day low line increases.
However, the market then starts to drop and we get stopped out and go short very early in August. This trade loses us about 200 pips. The market then plunges at the beginning of September. The stop loss is starting to move lower but is still very high above the current price. We are up about 1,900 pips on a mark-to-market basis. But then a sharp rally starts in the early part of September that hits the top of the 20-day channel in the third week of September where we are stopped out with a profit of about 1,000 pips and go long at the same time.
That position would then be stopped out in the first week of October for a loss of about 1,200 pips and we would also go short at the same time. We would still be short with an open profit of about 2,200 pips at the end of the chart.
This technique would be called the 20/20 system because we use the 20-day high/low to enter the position and the 20-day high/low to exit the position. Note that the 20/20 is essentially Donchian’s four-week rule (4WR), since there are 20 days in four weeks.
We would have ended up being profitable during this period of time but it would have been an aggravating profit. We’ll make some enhancements to the system to improve it. I don’t recommend using this system. I just wanted to show the concept of channel breakouts using the simple four-week rule. The 20/20 system is
profitable, but there are other superior methods you can use.
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
