It's based on the following assumptions about market behavior:
1. The strongest trending moves start from new market highs NOT market lows.
Those people who think buy low sell high is a great way to make money are wrong. If you don't buy breakouts from new highs, you will miss some of the best trends – period.
2. A trend in motion is more likely to continue than reverse.
We all know this is a basic building block of technical analysis and there is no better trend than one that is making new highs
3. A four week cycle is the dominant cycle in trading.
This can vary at times of course but the four week cycle is highly effective.
The original rules were used for trading commodities and can be summarized by:
Cover short positions and buy long whenever the price exceeds the highs of the previous 4 calendar weeks.
Liquidate long positions and sell short whenever the price falls below the lows of the previous 4 calendar weeks.
The original system being devised for commodities was designed to use a stop and reverse so the trader was always in the market with a position.
In a non trading market it can get whipsawed a solution to this problem is to enter on the 4 week rule (the breakout), and to exit on a shorter time period such as 1 or 2 weeks. With this system, a four week "breakout" would be needed to initiate a new position, but a one or two week signal in the opposite direction would mean liquidation of the position.
Why It Works
This system is based on sound technical principles with signals that are mechanical and clear-cut. It is trend-following so a trader is virtually guaranteed to be on the right side of every trend.
It also follows the often quoted trading wisdom – "let profits run, while cutting losses short". Another advantage is fewer trades, which means less time being spent looking at the market and finally you don't even need a computer!
People often say technology helps – but for many traders its a hindrance they think being clever will make them money, well consider this 95% of traders lost 100 years ago and the its the same ratio before yet computers today are more powerful than the one mission control used to land man on the moon!
Don't be fooled by simplicity it can be very profitable.
Being a trend-following system, it is not going to catch market tops and bottoms ( but how many systems do that though?) however, the 4 week rule works as well as any other trend-following system but with the benefit of incredible simplicity.
You might be saying that won't work – well go and try it on a strong trending currency market like the euro, Canadian dollar or Australian dollar and back test it and in a number of strong trending markets and you will see it does.
Don't be led to believe that if its simple it won't work – all the best forex trading systems are simple.
You don't get paid for being clever you get paid for being right – Period.
Today, traders always like to trade something different or obscure but if you want a simple system, by a trading legend, that's hard to beat – try Richard Donchian 4 week rule It's been part of some of the true great traders box of tools and should be in yours to.