Donchian Channels — Catching the Trend With the Four Week Rule

Preface

This article aims to educate the reader about a trading system that I use religiously, and think more people should implement for deciding which side of the market they choose to be on (Bull/Bear). While I consider myself to know what I’m talking about at least in this aspect, I encourage everyone to do their own research, after all I’m just some random guy posting an article on the internet (I’ll provide suggested sources under the references tab). Also if you have any questions, please feel free to send me a DM on twitter - I’ll be more than happy to answer any questions and receive any feedback.

Introduction

In the trading world, people are obsessed with trying to buy exact bottoms and sell exact tops, causing traders to enter positions prematurely and/or take profits too early (if they take profits at all). Wouldn’t it be good if there was a system that enabled traders to be on the right side of every major move?

In 1970, results were published in a booklet entitled “The Traders Notebook” comparing the best known commodity trading systems. What was found is that the most successful trading system was the Four Week Rule, developed by Richard Donchian.

Later on in 1990 in “The Financial Review”, an extensive study was conducted on data collected between 1976 and 1986 which compared 23 technical trading systems. What was found is that channel breakout (The Four Week Rule) and moving average crossover trading systems came out on top for generating consistent profits.

What is the Four Week Rule?

The 4 week rule is as simple as it gets. It can be broken down into two parts;

  1. When the price exceeds the high of the four preceding full calendar weeks, open a long position and close any shorts.
  2. When the price falls below the low of the four preceding full calendar weeks, open a short position and close any longs.

In theory, the trader will continuously have a position open. However, keen readers would have spotted an obvious weak spot of this trading method - it is important to note that the Four Week Rule does not work well in sideways markets, due to price generally trading within a range.

Bitcoin between the dates 10 October 2018 and 1 June 2019

As can be seen above, a short position was indicated on 14 November 2018 as prices closed below the four week low, and a long position on 18 February 2019 as prices closed above the four week high.

Implementation with Trading View

Open up your trading view and search for “Donchian Channels” under the “Indicators” tab. Your chart will look similar to this:

Donchian Channels, by default, are setup for traditional markets:

  • Stock Market: Input = 20 (5 Trading days x 4 Weeks = 20)

So we need to modify the inputs for a 24/7 market. The input should be as follows (it is important to note that I primarily use this method on the daily chart):

  • 24/7 Markets: Input = 28 (7 Trading days x 4 Weeks = 28)

Note: Donchian Channels can be used on any time frame, just be sure to change the inputs. For example:

  • for weekly charts change the input to 4;
  • for 12 hourly charts, change the input to 40 for traditional markets and 56 for 24/7 markets and so on and so forth.

For people willing to trade Cryptocurrency, set your chart to the daily, open up the inputs and change the Length to 28:

Your chart will now look similar to this:

Using a modified version of Donchian Channels, we can see that long positions are indicated by a green check mark, and short positions by a red check mark:

Advantages

  • It is extremely simple;
  • Due to it being a trend following system, it will allow you to be on the right side of every important move; “Let profits run, cut losses short.”

Disadvantages

  • You won’t catch the top or bottom - though does any indicator allow you to do that?
  • As stated earlier, this method does not work well in trend-less / sideways markets. The red box in the image above shows a somewhat choppy market, and using this method would have meant constantly switching from long to short with little to no profits.

How I use Donchian Channels

This is where we move from “fact” and more into “opinion”. This is what I personally use and I encourage everyone to develop their own methods, after all the best trading system is the one you understand best.

Mid-line

One issue I found when using this method is that you tend to be buying into resistance and shorting into support. After reviewing chart histories, more times than not the price tended to retest the mid-line, making that a solid area to set bids. Here’s a couple of examples:

Weak signals

With any trading system, some signals are stronger than others. As can be seen on the example below, a short signal was indicated on 6 February 2019. Taking this trade would have resulted in a loss of profits (although you still would have been up overall).

While I’m still testing this method, I look for a price close of at least 3–5% above/below the previous highs/lows. This to me shows strength in the direction.

Moving Average Cross

A moving average (MA) crossover has been proven to be a reliable trading system, so why not use it? Recently I have added a MA crossover into my trading setup to compliment my Donchian Channels. The goal of the MA crossover is not to take a trade based solely on it, but to use it as an indicator of price direction change / strength in the trend. I have setup the MA’s on a 2 week crossover to work within my Donchain Channels, as can be seen below:

While the price dipped below the MA’s shown within the red box, it was still above the mid-line and no sell signal was developed. I decided to sit on my hands and stick to my long position, which, as can be seen, ended up being the right move.

Conclusion

Overall I find this system easy to understand and effective in reducing my own bias when it comes to trading. However different systems work for different people - it is important that you develop your own system which you understand best.

If you want to get into contact with me, follow me on twitter and send me a message - I’ll be happy to answer any questions!

References

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