Heating Oil Futures Trading Strategy: Riding Trends With The Donchian Channel

In this article, we will try to develop a trading system on the CME-listed Heating Oil (NY Harbor ULSD), with the idea of diversifying into energy futures. Similar to gasoline futures (RBOB Gasoline), this is a smaller instrument in terms of volume than the better-known Crude Oil. Still, it has the standard trend-following behavior typical of many energy futures. In this article, we will try to exploit the nature of the market by using a Donchian Channel as the driver of the strategy.

The similarities between Heating Oil (HO) futures and RBOB Gasoline futures also relate to other aspects that one must consider before trading these instruments: the risks one faces are certainly greater than when using other energy futures, as HO and RBOB are less liquid and therefore more prone to slippage in order execution, especially during the overnight hours when volumes tend to be lower. No less important is the "big point value," i.e., the value of a single point: in this case, it is worth just over $42,000, and at the Heating Oil quote to date of about $2.9, this gives a single contract value of about $120,000 in an instrument that has relatively high volatility.

Figure 1 – HO Future price trend from 01/01/2010 to the present

The Donchian Channel Indicator

Returning to the strategy engine, the Donchian Channel (also known as the Price Channel) is formed by two bands, one upper and one lower, representing the highest high and lowest low, respectively, of the last N periods. Its inventor, Richard Donchian, was nicknamed "the father of trend-following trading," not surprisingly since the Donchian Channel is an indicator that responds very well to classic breakout logic. Basically, when the upper or lower limit of the channel is broken, the market crosses the price limits within which it has been moving up to that point. In practice, the power ratios between buyers and sellers have become unbalanced on one side or the other so the conditions are in place for a long or short entry to try to jump on the trend, which should generate from there more easily. This does not exclude the possibility to also use this indicator for "mean reverting" strategies by buying at the lower channel and selling at the upper channel.

The structure of the Donchian Channel is strongly reminiscent of another famous technical analysis indicator, the Bollinger Bands. Like the latter, the Donchian Channel can also be used as a volatility indicator, as it widens and narrows depending on price movements, albeit in a way that could be described as less reactive.

Figure 2 – Example of Donchian Channel

HO Trading Using The Donchian Channel indicator

We can approach the definition of an HO trading system by considering that energy futures respond very well to classic breakout trend-following logic. This means, for example, that when a breakout of a previous high or low occurs, the market usually tends to continue in that direction.

Specifically, this strategy waits for the prices to cross the upper Donchian channel (breakout) to enter long, or vice versa, the lower channel to enter short. The channel is calculated using the classic 20 periods. The strategy is tested on a 60-minute time frame, with a data history ranging from January 2010 to December 2021, so all data from 2022 is available as an "out of sample" period for testing the strategy's effectiveness.

Positions can be kept open for a few days at most, which means that it is possible to go overnight. However, consideration is being given to setting a maximum duration. This is because the entry signal would become less important over time. In addition, an operational time window excludes the first and last trading hours (thus 7:00 p.m. to 4:00 p.m. exchange time) to avoid price movements that sometimes occur at the beginning and end of the session but are not a sign of a proper trend start.

A stop loss of $2,000 and a take profit of $5,000 are used as values for the first attempt.

Figures 3, 4, and 5 show the metrics obtained with the above-mentioned strategy.

Figure 3 – Strategy performance report of the HO trading system using the Donchian Channel

Figure 4 - Equity curve of the HO trading system using the Donchian Channel

Figure 5 – Total Trade Analysis of the HO trading system using the Donchian Channel

Since no parameters have been optimized yet, the strategy shows encouraging results and a rising equity curve, although not very consistent. Thus, the approach seems correct and confirms the trend-following nature of this underlying asset. However, refinement is needed to think about its use in real trading. In particular, a sore point is the Average Trade, which averages about $65, which does not guarantee that it can bear the commission costs and slippage typical of this underlying asset.

HO Trading System Optimization Using The Donchian Channel

Let us try to improve the metrics of the strategy by acting on the most important parameters.

In the first step, we will try to optimize the number of periods over which the Donchian channel is calculated to see if there are values that work better in the hourly time frame we have chosen compared to the standard 20 periods. When we optimize the period between 5 and 240 (equivalent to 10 trading days), we find a suitable stability range around the value 164, with an excellent average trade and a drawdown that is practically halved compared to the initial value without affecting the net profit too much.

Figure 6 – Optimization of the Donchian Channel calculation period

Another refinement could be to limit the time window in which positions can be opened. Indeed, traded volumes tend to be lower in the early trading hours until about 3:00 a.m., which could have a negative impact on the results due to the lower importance of the movements taking place and the higher probability of slippage. From the optimization results, it appears that by starting trading at 10:00 a.m. and ending at 3:00 p.m., one can bring the Average Trade to $460 while also increasing the net profit and the net profit/drawdown ratio (indicated as 'custom criteria' in the optimization results).

Figure 7 – Operational window optimization, startTime at the top and endTime at the bottom

The resulting equity curve is more consistent than the initial one, the metrics have improved, and the strategy looks promising. This does not change the fact that one could think about further improvements, such as stop losses and take profits, or limiting the duration of trades beyond 5-6 days, which risk losing significance in relation to the signal that generated them. But as always, it is left to the readers to experiment and try to improve this system further.

Figure 8 – Optimized equity curve of the HO trading system using the Donchian Channel

Conclusions About The HO Trading System Using The Donchian Channel

In summary, the trend-following and breakout approach applied to the Donchian Channel signals is an excellent approach to trading the Heating Oil futures, as with other energy futures. Of course, making the necessary adjustments must be made case-by-case.

Until next time and happy trading!

Andrea Unger