The Weekly Rule
posted under
Philosophy of Technical Analysis
by ceecabolos
There are other alternatives to the moving average as a trend-following device. One of the best known and most successful of these techniques is called the weekly price channel or, simply, the weekly rule. This technique has many of the benefits of the moving average, but is less time consuming and simpler to use.
With the improvements in computer technology over the past decade, a considerable amount of research has been done on the development of technical trading systems. These systems are mechanical in nature, meaning that human emotion and judgment are eliminated. These systems have become increasingly sophisticated. At first, simple moving averages were utilized. Then, double and triple crossovers of the averages were added. The averages were then linearly weighted and exponentially smoothed. These systems are primarily trend-following, which means their purpose is to identify and then trade in the direction of an existing trend.
With the increased fascination with fancier and more complex systems and indicators, however, there has been a tendency to overlook some of the simpler techniques that continue to work quite well and have stood the test of time. We're going to discuss one of the simplest of these techniques—the weekly rule.
In 1970, a booklet entitled the Trader's Notebook was published by Dunn & Hargitt's Financial Services in Lafayette, Indiana. The best known commodity trading systems of the day were computer-tested and compared. The final conclusion of all that research was that the most successful of all the systems tested was the 4 week rule, developed by Richard Donchian. Mr.
Donchian has been recognized as a pioneer in the field of commodity trend trading using mechanical systems. (In 1983, Managed Account Reports chose Donchian as the first recipient of the Most Valuable Performer Award for outstanding contributions to the field of futures money management, and presents The Donchian Award to other worthy recipients.)
More recent work done by Louis Lukac, former research director at Dunn & Hargitt and currently president of Wizard Trading (a Massachusetts CTA) supports the earlier conclusions that breakout (or channel) systems similar to the weekly rule continue to show superior results. (Lukac et al.)*
Of the 12 systems tested from 1975-84, only 4 generated significant profits. Of those 4, 2 were channel breakout systems and one was a dual moving average crossover system. A later article by Lukac and Brorsen in The Financial Review (November 1990) published the results of a more extensive study done on data from 1976-86 that compared 23 technical trading systems. Once again, channel breakouts and moving average systems came out on top. Lukac finally concluded that a channel breakout system was his personal choice as the best starting point for all technical trading system testing and development.
The 4 Week Rule
The 4 week rule is used primarily for futures trading.
The system based on the 4 week rule is simplicity itself:
1. Cover short positions and buy long whenever the price exceeds the highs of the four preceding full calendar weeks.
2. Liquidate long positions and sell short whenever the price falls below the lows of the four preceding full calendar weeks.
The system, as it is presented here, is continuous in nature, which means that the trader always has a position, either long or short. As a general rule, continuous systems have a basic weakness. They stay in the market and get "whipsawed" during trendless market periods. It's already been stressed that trend-following systems do not work well when markets are in these sideways, or trendless phases.
* See Bibliography
The 4 week rule can be modified to make it noncontinuous. This can be accomplished by using a shorter time span—such as a one or two week rule—for liquidation purposes. In other words, a four week "breakout" would be necessary to initiate a new position, but a one or two week signal in the opposite direction would warrant liquidation of the position. The trader would then remain out of the market until a new four week breakout is registered.
The logic behind the system is based on sound technical principles. Its signals are mechanical and clearcut. Because it is trend following, it virtually guarantees participation on the right side of every important trend. It is also structured to follow the often quoted maxim of successful trading—"let profits run, while cutting losses short." Another feature, which should not be overlooked, is that this method tends to trade less frequently, so that commissions are lower. Another plus is that the system can be implemented with or without the aid of a computer.
The main criticism of the weekly rule is the same one leveled against all trend-following approaches, namely, that it does not catch tops or bottoms. But what trend-following system does? The important point to keep in mind is that the four week rule performs at least as well as most other trend-following systems and better than many, but has the added benefit of incredible simplicity.
Adjustments to the 4 Week Rule
Although we're treating the four week rule in its original form, there are many adjustments and refinements that can be employed. For one thing, the rule does not have to be used as a trading system. Weekly signals can be employed simply as another technical indicator to identify breakouts and trend reversals. Weekly breakouts can be used as a confirming filter for other techniques, such as moving average crossovers. One or 2 week rules function as excellent filters. A moving average crossover signal could be confirmed by a two week breakout in the same direction in order for a market position to be taken.
Shorten or Lengthen Time Periods for Sensitivity
The time period employed can be expanded or compressed in the interests of risk management and sensitivity. For example, the time period could be shortened if it is desirable to make the system more sensitive. In a relatively high priced market, where prices are trending sharply higher, a shorter time span could be chosen to make the system more sensitive. Suppose, for example, that a long position is taken on a 4 week upside breakout with a protective stop placed just below the low of the past 2 weeks. If the market has rallied sharply and the trader wishes to trail the position with a closer protective stop, a one week stopout point could be used.
In a trading range situation, where a trend trader would just as soon stay on the sidelines until an important trend signal is given, the time period could be expanded to eight weeks. This would prevent taking positions on shorter term and premature trend signals.
The 4 Week Rule Tied to Cycles
Earlier in the chapter reference was made to the importance of the monthly cycle in commodity markets. The 4 week, or 20 day, trading cycle is a dominant cycle that influences all markets. This may help explain why the 4 week time period has proven so successful. Notice that mention was made of 1, 2, and 8 week rules. The principle of harmonics in cyclic analysis holds that each cycle is related to its neighboring cycles (next longer and next shorter cycles) by 2.
In the previous discussion of moving averages, it was pointed out how the monthly cycle and harmonics explained the popularity of the 5, 10, 20, and 40 day moving averages. The same time periods hold true in the realm of weekly rules. Those daily numbers translated into weekly time periods are 1, 2, 4, and 8 weeks. Therefore, adjustments to the 4 week rule seem to work best when the beginning number (4) is divided or multiplied by 2. To shorten the time span, go from 4 to 2 weeks. If an even shorter time span is desired, go from 2 to 1. To lengthen, go from
4 to 8. Because this method combines price and time, there's no reason why the cyclic principle of harmonics should not play an important role. The tactic of dividing a weekly parameter by 2 to shorten it, or doubling it to lengthen it, does have cycle logic behind it.The 4 week rule is a simple breakout system. The original system can be modified by using a shorter time period—a 1 or 2 week rule—for liquidation purposes. If the user desires a more sensitive system, a 2 week period can be employed for entry signals. Because this rule is meant to be simple, it is best addressed on that level. The 4 week rule is simple, but it works.(Charting packages allow you to plot price channels above and below current prices to spot channel breakouts. Price channels can be used on daily,
With the improvements in computer technology over the past decade, a considerable amount of research has been done on the development of technical trading systems. These systems are mechanical in nature, meaning that human emotion and judgment are eliminated. These systems have become increasingly sophisticated. At first, simple moving averages were utilized. Then, double and triple crossovers of the averages were added. The averages were then linearly weighted and exponentially smoothed. These systems are primarily trend-following, which means their purpose is to identify and then trade in the direction of an existing trend.
With the increased fascination with fancier and more complex systems and indicators, however, there has been a tendency to overlook some of the simpler techniques that continue to work quite well and have stood the test of time. We're going to discuss one of the simplest of these techniques—the weekly rule.
In 1970, a booklet entitled the Trader's Notebook was published by Dunn & Hargitt's Financial Services in Lafayette, Indiana. The best known commodity trading systems of the day were computer-tested and compared. The final conclusion of all that research was that the most successful of all the systems tested was the 4 week rule, developed by Richard Donchian. Mr.
Donchian has been recognized as a pioneer in the field of commodity trend trading using mechanical systems. (In 1983, Managed Account Reports chose Donchian as the first recipient of the Most Valuable Performer Award for outstanding contributions to the field of futures money management, and presents The Donchian Award to other worthy recipients.)
More recent work done by Louis Lukac, former research director at Dunn & Hargitt and currently president of Wizard Trading (a Massachusetts CTA) supports the earlier conclusions that breakout (or channel) systems similar to the weekly rule continue to show superior results. (Lukac et al.)*
Of the 12 systems tested from 1975-84, only 4 generated significant profits. Of those 4, 2 were channel breakout systems and one was a dual moving average crossover system. A later article by Lukac and Brorsen in The Financial Review (November 1990) published the results of a more extensive study done on data from 1976-86 that compared 23 technical trading systems. Once again, channel breakouts and moving average systems came out on top. Lukac finally concluded that a channel breakout system was his personal choice as the best starting point for all technical trading system testing and development.
The 4 Week Rule
The 4 week rule is used primarily for futures trading.
The system based on the 4 week rule is simplicity itself:
1. Cover short positions and buy long whenever the price exceeds the highs of the four preceding full calendar weeks.
2. Liquidate long positions and sell short whenever the price falls below the lows of the four preceding full calendar weeks.
The system, as it is presented here, is continuous in nature, which means that the trader always has a position, either long or short. As a general rule, continuous systems have a basic weakness. They stay in the market and get "whipsawed" during trendless market periods. It's already been stressed that trend-following systems do not work well when markets are in these sideways, or trendless phases.
* See Bibliography
The 4 week rule can be modified to make it noncontinuous. This can be accomplished by using a shorter time span—such as a one or two week rule—for liquidation purposes. In other words, a four week "breakout" would be necessary to initiate a new position, but a one or two week signal in the opposite direction would warrant liquidation of the position. The trader would then remain out of the market until a new four week breakout is registered.
The logic behind the system is based on sound technical principles. Its signals are mechanical and clearcut. Because it is trend following, it virtually guarantees participation on the right side of every important trend. It is also structured to follow the often quoted maxim of successful trading—"let profits run, while cutting losses short." Another feature, which should not be overlooked, is that this method tends to trade less frequently, so that commissions are lower. Another plus is that the system can be implemented with or without the aid of a computer.
The main criticism of the weekly rule is the same one leveled against all trend-following approaches, namely, that it does not catch tops or bottoms. But what trend-following system does? The important point to keep in mind is that the four week rule performs at least as well as most other trend-following systems and better than many, but has the added benefit of incredible simplicity.
Adjustments to the 4 Week Rule
Although we're treating the four week rule in its original form, there are many adjustments and refinements that can be employed. For one thing, the rule does not have to be used as a trading system. Weekly signals can be employed simply as another technical indicator to identify breakouts and trend reversals. Weekly breakouts can be used as a confirming filter for other techniques, such as moving average crossovers. One or 2 week rules function as excellent filters. A moving average crossover signal could be confirmed by a two week breakout in the same direction in order for a market position to be taken.
Shorten or Lengthen Time Periods for Sensitivity
The time period employed can be expanded or compressed in the interests of risk management and sensitivity. For example, the time period could be shortened if it is desirable to make the system more sensitive. In a relatively high priced market, where prices are trending sharply higher, a shorter time span could be chosen to make the system more sensitive. Suppose, for example, that a long position is taken on a 4 week upside breakout with a protective stop placed just below the low of the past 2 weeks. If the market has rallied sharply and the trader wishes to trail the position with a closer protective stop, a one week stopout point could be used.
In a trading range situation, where a trend trader would just as soon stay on the sidelines until an important trend signal is given, the time period could be expanded to eight weeks. This would prevent taking positions on shorter term and premature trend signals.
The 4 Week Rule Tied to Cycles
Earlier in the chapter reference was made to the importance of the monthly cycle in commodity markets. The 4 week, or 20 day, trading cycle is a dominant cycle that influences all markets. This may help explain why the 4 week time period has proven so successful. Notice that mention was made of 1, 2, and 8 week rules. The principle of harmonics in cyclic analysis holds that each cycle is related to its neighboring cycles (next longer and next shorter cycles) by 2.
In the previous discussion of moving averages, it was pointed out how the monthly cycle and harmonics explained the popularity of the 5, 10, 20, and 40 day moving averages. The same time periods hold true in the realm of weekly rules. Those daily numbers translated into weekly time periods are 1, 2, 4, and 8 weeks. Therefore, adjustments to the 4 week rule seem to work best when the beginning number (4) is divided or multiplied by 2. To shorten the time span, go from 4 to 2 weeks. If an even shorter time span is desired, go from 2 to 1. To lengthen, go from
4 to 8. Because this method combines price and time, there's no reason why the cyclic principle of harmonics should not play an important role. The tactic of dividing a weekly parameter by 2 to shorten it, or doubling it to lengthen it, does have cycle logic behind it.The 4 week rule is a simple breakout system. The original system can be modified by using a shorter time period—a 1 or 2 week rule—for liquidation purposes. If the user desires a more sensitive system, a 2 week period can be employed for entry signals. Because this rule is meant to be simple, it is best addressed on that level. The 4 week rule is simple, but it works.(Charting packages allow you to plot price channels above and below current prices to spot channel breakouts. Price channels can be used on daily,
Comment Form under post in blogger/blogspot