Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

CHANNEL BREAKOUT

As stated in Chapter 2, channel breakout is a purely price-triggered trend-following system. Although our backtest will employ Donchian's original 20-day stop and reverse parameters, readers are encouraged to experiment with modifications, including lengthening the parameter (e.g., setting n period to 70) to reduce false breakouts, as well as changing the exit condition (e.g., entry when market breaks 20-day highs/lows and exit when it breaks 10-day highs/low) to transform the stop and reverse system into one that allows for neutrality.

Because the original parameters proposed by Donchian do not account for shifts in market volatility per se, another worthwhile experiment is the examination of filters that would cut loses during periods of high volatility. A simple example of this approach would be the addition of a stop loss based on 1 to 5 percent of the asset's value at the time of entry (see the “Cutting Losses” section later in this chapter).

Another potential drawback to Donchian's approach is that signals are triggered at or just beyond horizontal support and resistance levels. This could potentially entice large speculative players to trigger stops positioned at these levels, resulting in false breakouts. Readers are encouraged to experiment with various solutions to the problem. One particularly simple and robust solution is offered by Art Collins, author of numerous articles on trading systems, who proposes the addition of a filter requiring the market ...