Four-Week Rule Boosts Winning Trades

By Michael Carr AAA

Trading systems are usually thought of as complex computer programs requiring massive amounts of data to calculate the best entry and exit parameters. But in trading, often the best solution is the simplest. In fact, one of the best known trading systems doesn't even require a computer to run. Read on as we take a look at the weekly rule system and show you how this simple system can help you profit from a trade.

Profiting From the Trend
Trend following is a well-known concept underlying many successful trading systems. Probably the first such system was the weekly rule devised by Richard Donchian. Test results for this system were published as early as 1970, and it was found to be the most profitable system then known.

Donchian was called the "father of modern commodities trading methods," and was the first to manage a commodities fund that was available to the general public. He is believed to have developed the idea of trend following systems in the 1950s.

The Strategy
The weekly rule, in its simplest form, buys when prices reach a new four-week high and sells when prices reach a new four-week low. A new four-week high means that prices have exceeded the highest level they have reached over the past four weeks. Likewise, a four-week new low means prices are trading lower than they have at any time over the past four weeks. This system is always in the market, long or short. Known simply as the four-week rule (4WR), this is the exact system designed and used by Donchian.

This strategy will consistently be on the right side of all the big moves in a market. However, the strategy also has a low percentage of winning trades. The problem is that most markets trend about one-third of the time. In some markets, the 4WR may be right less than 40% of the time. The other trades are usually small losses, which occur while the market consolidates with choppy price action. (For more, see our Trading Systems tutorial.)

Using the Four-Week Rule
As an example of the 4WR, we can look at Google (Nasdaq:GOOG) in Figure 1. This shows a typical winning long trade. When a new four-week high was reached, GOOG was bought; it was sold about 10 weeks later when it made a new four-week low. The trade resulted in an impressive 18% gain. The problem with this trade is that it was up by more than 30% at one point, and gave back nearly half its profits before giving a sell signal.

Figure 1: Daily chart of GOOG showing four week rule signals

The 4WR can work equally well on the short side. In Figure 2, we see a winning trade in Goldman Sachs (NYSE:GS). This trade also resulted in a win of more than 18%. But it had been ahead as much as 25% and was closed after giving back a significant portion of the profits.

Figure 2: Daily chart of GS showing four week rule signals

Refining the Strategy
One way to address the problem of staying in a trade too long is to change the exit rules. Instead of following the original 4WR to exit a position, traders can exit when a moving average is broken. For example, applying a 10-day moving average as the exit criteria on the GOOG trade shown in Figure 1 would have increased the profits on that trade by about 25%. A 10-day moving average was selected because it is one-half of the entry signal (four weeks is 20 trading days), but any time period shorter than the entry signal can be used. (For background reading, see the Moving Averages tutorial.)

Trend Filtering
Another use of the 4WR is as a trend filter on the overall market. For many traders, it can be a challenge to determine whether the market is bullish or bearish on a short-term basis. Applying the 4WR allows traders to objectively define the trend. If the market's most recent signal under this system is a buy, the trader can be confident that the market is in an uptrend. Downtrends can be defined as times when the latest 4WR signal was a sell; in other words, the market has made a new four-week low more recently than it made a new four-week high. Using the 4WR as a filter, the trader would look for the 4WR to be on a buy signal before entering new long positions. Short positions would only be entered when the market is on a 4WR sell signal.

Finding Longer Term Trends
This versatile system can also be applied to identify the longer term trend. This can be done by applying Dow theory, a widely followed barometer of the health of the market. Analysts look for the action in the Dow Jones Transportation Average to confirm the direction of the Dow Jones Industrial Average. When both averages make new highs, we are in a confirmed bull market. New lows in both averages signal a confirmed bear market. Divergences between the averages lead most analysts to express caution about the trend. (To learn more, read the Dow Theory tutorial.)

One problem with applying Dow theory is that the rules are subjective, depending on how an analyst defines a new high or new low. It is possible for two skilled practitioners to look at the same charts and disagree on the signals. Applying the 4WR prevents this possibility. Rather than subjectively determining a new high or low, the 4WR defines, in advance, when a signal is generated and all analysts using the 4WR will arrive at the same conclusion.

The 4WR makes a great addition to any trader's toolbox. All traders should consider adapting the 4WR to their trading styles. Keep in mind that there is nothing magic about four weeks. Traders may choose to use signals based on shorter or longer timeframes. Entry and exit signals can be asymmetric, for example entering on 4WR signals but exiting on two-week new lows. As noted, moving averages can also be used to generate exit signals. The 4WR can be combined with indicators, such as the relative strength index or moving average convergence divergence, as a filter on these signals. The possible applications of the 4WR are limited only by the trader's imagination, so experiment a little and find out which system produces the best results for you.

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