The 4-week rule is a straightforward trend-following trading system that guides traders on when to enter or exit positions in the market. It is an example of a broader weekly rule system.
Understanding the 4 Week Rule
At its core, the 4-week rule is a momentum-based strategy designed to capture trends in asset prices. It was established by Richard Donchian, a pioneer in commodity trading and technical analysis. This rule operates on the principle that significant price movements, either upward or downward, often indicate the start or continuation of a trend. By adhering to this system, traders aim to capitalize on these trends, buying into strength and selling into weakness.
How the 4-Week Rule Functions
The application of the 4-week rule is distinctly simple, focusing on recent price extremes to generate trade signals. It relies on monitoring the highest and lowest prices an asset has reached over a trailing four-week period.
Here’s how it works:
- Buy Signal: A buy signal is generated when the price of an asset reaches a new four-week high. This indicates strong upward momentum, suggesting a potential continuation of an uptrend.
- Sell Signal: Conversely, a sell signal occurs when the price of an asset reaches a new four-week low. This signifies strong downward momentum, indicating a potential continuation of a downtrend or a reversal to the downside.
This can be summarized in the following table:
| Action | Condition | Implication |
|---|---|---|
| Buy | Price reaches a new 4-week high | Strong upward momentum; potential uptrend |
| Sell | Price reaches a new 4-week low | Strong downward momentum; potential downtrend |
Practical Application and Insights
The simplicity of the 4-week rule makes it accessible to traders of varying experience levels. It removes much of the subjectivity often associated with trading decisions, providing clear, objective entry and exit points.
Example Scenario:
Imagine a stock that has been trading between \$50 and \$55 for the past few months.
- Scenario A (Buy Signal): If, over the last four weeks, the highest price the stock reached was \$55, and today it trades at \$55.50, breaking that \$55 high, the 4-week rule would trigger a buy signal. A trader following this rule would open a long position.
- Scenario B (Sell Signal): If, over the last four weeks, the lowest price the stock reached was \$50, and today it trades at \$49.50, falling below that \$50 low, the 4-week rule would trigger a sell signal. A trader might then close a long position or open a short position.
This system is often favored by traders who believe that momentum is a key driver of market prices and that following trends can lead to profitable outcomes. Its mechanical nature helps to avoid emotional decision-making, which can be a significant advantage in volatile markets.
