Richard Donchian, the creator of the famous "4 Week Rule" system was born in Hartford, Connecticut in 1905.

After graduating from Yale University with a Bachelor degree in economics Donchian became interested in the stock market. After reading "Reminiscences of a Stock Operator" by Jesse Livermore, Richard started trading but lost money during the "Black Thursday" crash of 1929.

Nevertheless he didn't get discouraged and after studying technical analysis for one year, restarted his Wall Street career in 1930 and by 1933 was an account executive and securities analyst with Hemphill, Noyes and Co.

Richard Donchian developed several trading methods and we will take a look at them in this article.

Some of you are probably thinking "This is all very interesting but it's also very old. Can a system developed in mid-twentieth century still work in today's dynamic global markets?"

Let's find out...

Donchian's Four-Week Rule

Donchian's four-week rule which forms the basis of many modern trading systems are surprisingly simple:

1. Go long (and cover shorts) when the current price exceeds the highs of the previous four full calendar weeks.
2. Go short (and liquidate longs) when the current price falls below the lows of the previous four full calendar weeks.
3. Roll forward if necessary into the next contract on the last day of the month preceding expiration.

If the system is run with a SAR (stop and reverse), it will always maintain a position in the market (either long or short).

Does it work?

Back test and see for yourself! Many profitable modern day trading systems are based on this principle. Of course it works much better in trending markets than in a choppy sideways market and here you may wish to consider some filters.

A common solution to this problem is to enter on the 4 week rule (the breakout), and to exit on a shorter time frame such as 1 or 2 weeks.

Traders can also use other exit rules i.e. exit when a moving average is broken. For example, applying a 10-day moving average as the exit - A 10-day moving average is one-half of the entry signal (four weeks is of course 20 trading days) is period we like. You can also experiment with ADX RSI and MACD filters if you wish.

Many traders ignore this system; after all it's not trendy or complex like some of the newer approaches - but it works.

Simple systems work better than complicated ones as they have fewer elements to break. The 4 week rule is simple but you can customize it to restrict losses, by adding filter and it will have you on the right side of every major move - do that and you have great profit potential.

Turtle Trading system

Of the modern day systems based on Donchians methods the most popular is the Turtle System. You can get a PDF file explaining the Turtle system in detail in the Downloads section.

Donchian's 5- and 20-Day Moving Average System

Another popular system used by many traders is the 5- and 20-day moving averages system, which Donchian developed in 1961. It is not known why he chose these two values, however they do relate to the number of trading days in a week and a month, respectively.

Donchian's idea is to use a volatility-penetration criterion relative to the 20-day moving average, but with some added complication. The current penetration must not only cross the 20-day moving average but also exceed any previous 1-day penetration of a closing price by at least one volatility measure.

The 5-day moving average serves as a liquidation criterion (along with others) and is also modified by prior penetration and volatility. These features tend to make Donchianâ's volatility measurement "self-adjusting".

(Kaufman, P., The New Commodity Trading Systems and Methods, John Wiley and Sons, New York, 1987, page 86.)

Donchian Channels

Channels are indicators which usually look like curved lines that contain the price action. A common way to produce these channels is by plotting a moving average, then "moving" the moving average vertically up and vertically down by a fixed percentage of the price

To draw the Donchian's channels one must take the highest close and the lowest close, for the last N periods. These two lines form the upper and lower boundaries of the channel. A middle channel line is plotted, this is the mid point between the highest and lowest closes.

Donchian traded the long side of the market if the channel pointed upwards, buying on a retracement to the lower side. He traded the short side of the market if the channel pointed downwards, selling on rallies to the upper side of the channel or to the mid point line.

The Donchian Legacy

In the course of his career Donchian started the first publicly managed futures fund, coined the term "Trend Following" and developed several comprehensive trading methods which became the basis of many successful trading systems around the world.