Lesson 8: The “20:20” method – How do experts read
the chart?
The 20/20 Channel Breakout Trading System is a simple system that was first
suggested by Richard Donchian. Richard Donchian is considered to be a pioneer of
technical analysis. He was the first person to talk about channel breakouts. He
suggested a 4 week rule for trading channel breakouts. It was Richard Dennis, a
famous commodity trader, who used this channel breakout trading system
extensively and made a fortune in the commodities market.
Amazingly, Richard started with only $450 and in the next few years made a fortune
of around $150 million trading mostly channel breakouts. Trading Channel Breakouts
is a proven and tested trading strategy that has made many millionaires and should
be the most important part of your trading toolkit. This system lets you catch the big
moves in the market.
This 20/20 Channel Breakout System is the basic part of the Turtle Trading System
that Richard Dennis gave to his Turtles. Many turtles also made millions trading with
this simply 20/20 system. So, let’s go into the details of this 20/20 System.
20/20 means 20 day high and 20 day low. Richard Donchian had suggested the 4
week rule for trading channel breakouts. 4 weeks translate into 20 days. So, this is
how this system works. Every day, find the 20 day high and the 20 day low on the
asset that you want to trade. Place a buy order just above the 20 day high and a sell
order just below the 20 day low. Check again the next day. If the entry orders have
not been filled, again find the new 20 day high and the new 20 day low and replace
the previous entry orders with new entry orders. Do it every day till the entry orders
get filled.
In this chart we can see the Euro-Dollar pair breaking a 20 day low downwards.
In this case our sell order would be filled.
Suppose, you find the buy order filled. The sell order on the other extreme of the 20
day channel will work as your stop loss. Add one more sell order at this level. The
first sell order will take you out of the long trade when this price level is hit and the
second entry order will make you go short at this price level. In case of a short entry,
the buy order will become the stop loss and you will need to place another buy order.
So, if you are short, the first order will take you out when that price level is hit and the
second order will make you go long.
This is how classic channel breakout works, you go long and short.
Of course, not all breakouts are going to be successful and there is no way to
generate a 100% accurate system, but there are ways to increase the quality of entry
signals for the Donchian channel. It’s apparent that a significant amount of false
breakouts exist when momentum is not supporting the move. So one aught to use
the RSI strength and momentum indicator to filter out low-momentum breakouts
which are often false breakouts.
Next, we add a long-term moving average; in the scenario below we added the
100-period moving average which is an excellent filter tool that helps you separate
between long and short scenarios. Whenever price is above the 100-period moving
average, you would only look for breakouts to the upside; and when price is below
the 100-period moving average, you only look for short breakouts.
This screenshot includes the 100-period moving average. The amount of signals has
been reduced while, at the same time, the quality of the signals has been improved
significantly. There are only 3 false signals left.
That was just an example of how adding trading tools and indicators can help you
improve the quality of your trade entries. The approach highlights the importance of
combining trading tools and concepts that support your trading style and objective in
order to filter out low probability entries.
Now that you have a better understanding about how to improve the quality of trade
signals, we can take a look at position sizing. Especially for breakout and
trend-following traders, there is a specific position sizing strategy that can help you
improve the quality of your system even further.
“Scaling in” refers to the position sizing strategy of entering a fractional amount of
your intended position size first and as price moves in your favor, you add to the
winning position; and ideally move your stop loss to protect your profits so far.
There are two major benefits of scaling in:
On a fake breakout, your position will be relatively small because you haven’t yet
reached the full position.
Only when the breakout is strong and successful you reach your maximum position
size and fully capitalize on winning trades.
You have to be conscious of your trading style and build your approach around your
goals. As a breakout and trend-following trader, look for momentum and sentiment
tools that help you read what is going on and filter out trades with a lower probability.
On the other hand, if you fade false-breakouts, look for tools that help you identify
low momentum price movements into high-impact price areas.
And take it one step further and look beyond generating entry signals; structure your
position sizing and money management around your trading objectives. For every
trading style, there are techniques and principles that can improve the quality and
robustness of the system; think outside the box and start building your own, powerful
method and stop following generic advice.
This 20/20 Channel Breakout System still works but over the years some
improvements have been made like instead of 20/20 some use the 55/22 Channel
Breakout System in which you enter on the 55 day high and exit on the 20 day low.
You can practice this 20/20 Channel Breakout Strategy on your demo account and
see how it works.