The Weekly Rule

THE WEEKLY RULE

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.

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, weekly, or monthly charts. See Figures 9.11 and 9.12.)

Figure 9.11 A 20 day (4 week) price channel applied to Treasury Bond futures prices. A buy signal was given when prices closed above the upper channel (see circle). Prices have to close beneath the lower channel to reverse the signal.

Figure 9.12 A 4 month price channel applied to the S&P 500 Index. Prices crossed the upper channel in early 1995 (see circle) to give a buy signal which remains in effect 3 years later. A close beneath the lower line is needed to give a sell signal.

TO OPTIMIZE OR NOT

The first edition of this book included the results of extensive research produced by Merrill Lynch, which published a series of studies on computerized trading techniques applied to the futures markets from 1978-82. Extensive testing of various moving aver­age and channel breakout parameters was performed to find the best possible combinations in each futures market. The Merrill Lynch researchers produced a different set of optimized indicator values for each market.

Most charting packages allow you to optimize systems and indicators. Instead of using the same moving average in all mar­kets, for example, you could ask the computer to find the moving average, or moving average combinations, that have worked the best in the past for that market. That could also be done for daily and weekly breakout systems and virtually all technical indicators included in this book. Optimization allows technical parameters to adapt to changing market conditions.

Some argue that optimization helps their trading results and others that it doesn't. The heart of the debate centers on how the data is optimized. Researchers stress that the correct procedure is to use only part of the price data to choose the best parameters, and another portion to actually test the results. Testing the opti­mized parameters on "out of sample" price data helps ensure that the final results will be closer to what one might experience from actual trading.

The decision to optimize or not is a personal one. Most evi­dence, however, suggests that optimization is not the Holy Grail some think it to be. I generally advise traders following only a handful of markets to experiment with optimization. Why should Treasury Bonds or the German mark have the exact same moving averages as corn or cotton? Stock market traders are a different story. Having to follow thousands of stocks argues against opti­mizing. If you specialize in a handful of markets, try optimizing. If you're a generalist who follows a large number of markets, use the same technical parameters for all of them.

SUMMARY

We've presented a lot of variations on the moving average approach. Let's try to simplify things a bit. Most technicians use a combination of two moving averages. Those two averages are usually simple averages. Although exponential averages have become popular, there's no real evidence to prove that they work any better than the simple average. The most commonly used daily moving average combinations in futures markets are 4 and 9, 9 and 18, 5 and 20, and 10 and 40. Stock traders rely heavily on a 50 day (or 10 week) moving average. For longer range stock market analysis, popular weekly moving averages are 30 and 40 weeks (or 200 days). Bollinger Bands make use of 20 day and 20 week moving averages. The 20 week average can be converted to daily charts by utilizing a 100 day average, which is another use­ful moving average. Channel breakout systems work extremely well in trending markets and can be used on daily, weekly, and monthly charts.

THE ADAPTIVE MOVING AVERAGE

One of the problems encountered with the moving average is choosing between a fast or a slow average. While one may work better in a trading range market, the other may be preferable in a trending market. The answer to the problem of choosing between the two may lie with an innovative approach called the "adaptive moving average."

Perry Kaufman presents this technique in his book Smarter Trading. The speed of Kaufman's "adaptive moving average" auto­matically adjusts to the level of noise (or volatility) in a market. The AMA moves more slowly when markets are trending side­ways, but then moves more swiftly when the market is trending. That avoids the problem of using a faster moving average (and getting whipsawed more frequently) during a trading range, and using a slower average that trails too far behind a market when it is trending.

Kaufman does that by constructing an Efficiency Ratio that compares price direction with the level of volatility. When the Efficiency Ratio is high, there is more direction than volatility (favoring a faster average). When the ratio is low, there's more volatility than direction (favoring a slower average). By incorpo­rating the Efficiency Ratio, the AMA automatically adjusts to the speed most suitable for the current market.

ALTERNATIVES TO THE MOVING AVERAGE

 don't work all of the time. They do their best work when the market is in a trending phase. They're not very helpful during trendless periods when prices trade sideways. Fortunately, there's another class of indicator that performs much better than the moving average during those frustrating trading ranges. They're called oscillators and we'll explain them in the next chapter.