The Four Week Rule That Boosts Winning Trades
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.
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. 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.
Michael Carr can be contacted at Dunn Warren