A
technical charting interpretation of the
Donchian's Four Week Rule/Price Channel
By
Alex Martin
The
Four-week Rule is a basic method that may not
seem glamorous in the company of Fibonacci Numbers
and Japanese Candlesticks - but it is a profitable
method that is still used today.
Despite
its obvious shortcomings, as a trend-following
system, - it works well in up or down trends,
but not sideways trends - the Four-week Rule
is a tool that should be in every technical
analyst's repertoire. It was developed by Richard
Donchian in the early 1970s for commodities
and futures, and has been successfully applied
to stock analysis.
The
question is: How can you make it work for you?
Also
known as the "Price Channel" or "Donchian Channels,"
the Four-week Rule may be a basic tool. But
in the right hands, it can be powerful. In other
words, the rules may be simple, but applying
them is not. It works to the extent of the analyst's
abilities.
The
rules according to Donchian
The
Four-week Rule is a method that includes a set
of charting rules that are generated from the
price channel as well as a set of trading rules.
The mistake that some analysts make is to use
the price channels without the trading rules.
It is the combination of both sets of rules
that make the method effective.
The
charting rules
The
price channel generates the following signals
when applied to stock charts:
- buy signals
are produced when the price closes above
the upper band of the price channel; and,
- sell signals
are generated when the price closes below
the lower band of the price channel.
The
trading rules
- When the price
is at its highest in a four week period,
buy long and cover short positions.
- When the price
falls below the lows of a four week period,
sell short and liquidate long positions.
- This last
rule only applies to future traders, which
is "to roll forward, if necessary, into
the next contract on the last day of the
month prior to expiration.
As you
can see from Figure 2, trend-following systems
react to movements rather than attempting to
predict them. The trend breaks before the price
closes below the lower band of the price channel.
When
interpreting the price channel on charts, buy
signals are generated when the price channel
has closed above the upper band as shown in
Figure 3. The price channel tends to create
quite a few signals during the course of the
up trend.
For
those who use technical stock screeners, use
a screen with a rising close condition where
the price closes higher than the day before
for three days, as well as a price that closes
above the upper band. When we include a three-day
rising close as well as a price channel breakout,
the number of false signals is reduced as can
be seen in Figure 4 below.
The
stock used in all of the chart illustrations,
was found using the following stock screen:
- price-channel
buy, where the price penetrates the upper
band, as well as the condition that the
close for the last three days was higher
than the day before it.
(The
reverse does not apply during sell conditions,
three consecutive days down is not the best
pattern to wait for.)
Complimenting
the Four-week Rule
So what
can you do to increase the effectiveness of
the Four-week Rule so that you don't miss opportunities
due to the lagging indicators? And equally as
important, how can you ensure that you aren't
going to lose money in a volatile or sideways-trending
market due to false signals?
One
way to add certainty to the Four-week Rule is
to use complimentary indicators or methods to
generate additional signals that provide a warning
or confirmation.
For
example, you can use another trend-following
system, the Five- and 20-day Moving Averages
Method, also developed by Donchian, in conjunction
with the Four-week Rule, to create combined
signals that help you determine if the price
has really generated a strong trend. Note: The
rules in these two systems do not conflict with
one another.
The
Five- and 20-day Moving Averages Method
The
Five- and 20-day Moving Averages Method includes
several general and supplemental rules. These
rules where initially intended for currency
markets but can also be used to analyze stocks.
The
method consists of the following rules:
Basic
Rule A: Act on all closes that cross the 20-day
moving average by an amount exceeding by one
full unit the maximum penetration in the same
direction of any previous closing when the closing
was on the same side of the moving average.
Basic
Rule B: Act on all closes that cross the 20-day
moving average and close one full unit beyond
the previous 25 closes.
Basic
Rule C: Within the first 20 days after the first
day of a crossing that leads to a trading signal,
reverse on any close that crosses the 20-day
moving average and closes one full unit beyond
the previous 15 closes.
Basic
Rule D: Sensitive five-day moving average rules
for closing out positions and for reinstating
position in the direction of the 20-day moving
average are:
- Close out
positions when the currency closes below
the 5-day moving average for long positions
and above the 5-day moving average for short
positions, by at least one full unit more
than the greater of either the previous
penetration on the same side of the 5 day
moving average, or the maximum point of
any penetration within the preceding 25
trading days. Should the range between the
closing price in the opposite direction
to the Rule D closeout signal be greater
than the prior 15 days than the range from
the 20-day moving average in either direction
within 60 previous sessions, do not act
on Rule D closeout signals unless the penetration
of the 5-day moving average exceeds by one
unit the maximum range both above and below
the 5-day moving average during the preceding
25 sessions.
- Reinstate
positions in the direction of the basic
trend (a) when the condition in paragraph
1 are achieved, (b) If a new Rule A basic
trend is given, or (c) if new Rule B and
Rule C signals in the direction of the basic
trend are given by closing in a new low
or new high ground.
- Penetrations
of two units or less do not count as points
to be exceeded by Rule D unless at least
two consecutive closes were on the side
of the penetration when the point to be
exceeded was set up. (Richard Donchian,
December 1974 Futures article), as
quoted by Cornelius Luca in Technical
Analysis Applications in the Global Currency
Markets, 1997.
When
we look at the charting signals in Figure 5
generated by the 5- and 20-day method, we can
see that signals are generated earlier on in
the trend than the price channel shown in Figure
6.
To better
interpret the signals generated by the 5- and
20-day method, it is advisable to include an
MA cross system such as Japanese Crosses.
Combining
the 5- and 20- day moving average cross system
with the Four-week Rule can help to confirm
information about the potential trend change.
These modifications are not intended to replace
basic trend-following techniques - but to provide
more information about the trend when price
channel signals are generated.
In summary,
getting the Four-week Rule to work for you may
be as simple as - following the rules.
- Use it right
- as a method with a set of trading rules
and charting.
- Have discipline
- buy and sell strictly according to the
trading rules.
- Compensate
for its shortcomings - no system is perfect.
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