The Four Week Rule That Boosts Winning Trades
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. 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.
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 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 a 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.
Using the Four Week Rule
As an example of the 4WR, we can look at Google (before it split into different share classes in 2014) 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.
Fig 1: Daily chart of GOOG showing Four Week Rule signals Source: https://tradenavigator.com
The 4WR can work equally well on the short side. In Figure 2, we see a winning trade in Goldman Sachs. 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.
Fig 2: Daily chart of GS showing Four Week Rule signals Source: https://tradenavigator.com