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

  1. When the price is at its highest in a four week period, buy long and cover short positions.
  2. When the price falls below the lows of a four week period, sell short and liquidate long positions.
  3. 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:

  1. 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.
  2. 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.
  3. 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.

  1. Use it right - as a method with a set of trading rules and charting.
  2. Have discipline - buy and sell strictly according to the trading rules.
  3. Compensate for its shortcomings - no system is perfect