Richard Donchian is known as the father of trend following and any trader should study his work and make the principlies he taught part of their trading strategy. Today there numerous Forex robots all claiming they can make you money but Donchian's 4 Week Rule is free and will beat most of them! Here we will look at his work in more detail and see why, he is one of the best traders of all time.
Richard Davoud Donchian was born in Hartford, Connecticut, in September, 1905, after reading the book about Jesse Livermore, Reminiscences of a Stock Operator and suffering financial losses during the market crash of 1929, he began his study of technical analysis, believing technical analysis and charting was the way to make money.
In 1948 his focus changed from securities to the trading of commodities. He created "Futures, Inc," a pioneer publicly held commodity fund, based on the principle of diversification, an idea which was revolutionary at the time. He was later referred to as the 'father of modern commodities trading methods," having developed his "trend following," methods, he then used a mathematical system based on moving averages to forecast prices.
In 1960 he worked for Hayden Stone Inc., as Director of Commodity Research. From then until he died in 1993, he was associated with Hayden Stone and Shearson Lehman Brothers and became a Senior Vice President. In 1960 he started to write a weekly technical newsletter entitled "Commodity Trend Timing," In 1963 he was awarded a Chartered Financial Analyst degree from the Institute of Chartered Financial Analysts at the University of Virginia.
Richard Donchian was also a member of the Commodity Exchange, Inc., the New York Cotton Exchange, the New York Futures Exchange, the New York Society of Security Analysts, the American Statistical Association, the National Association of Future Trading Advisers, the Financial Forum, and listed in Who's Who in America. In June 1983 "Managed Accounts Report" nominated him as the first recipient of its "Most Valuable Performer Award," for outstanding contributions to the field of commodity money management.
The following trading guidelines were first published in 1934 and while over 70 years old, there still as applicable today as they ever were:
General Trading Guidelines
1. Beware of acting immediately on a widespread public opinion. Even if correct, it will usually delay the move.
2. From a period of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume increases.
3. Limit losses and ride profits, irrespective of all other rules.
4. Light commitments are advisable when market position is not certain. Clearly defined moves are signalled frequently enough to make life interesting and concentration on these moves will prevent unprofitable whip-sawing.
5. Seldom take a position in the direction of an immediately preceding three-day move. Wait for a one-day reversal.
6. Judicious use of stop orders is a valuable aid to profitable trading. Stops may be used to protect profits, to limit losses, and from certain formations such as triangular foci to take positions. Stop orders are apt to be more valuable and less treacherous if used in proper relation the the chart formation.
7. In a market in which upswings are likely to equal or exceed downswings, heavier position should be taken for the upswings for percentage reasons - a decline from 50 to 25 will net only 50% profit, whereas an advance from 25 to 50 will net 100%
8. In taking a position, price orders are allowable. In closing a position, use market orders."
9. Buy strong-acting, strong-background commodities and sell weak ones, subject to all other rules.
10. Moves in which rails lead or participate strongly are usually more worth following than moves in which rails lag.
11. A study of the capitalization of a company, the degree of activity of an issue, and whether an issue is a lethargic truck horse or a spirited race horse is fully as important as a study of statistical reports.
Technical Trading Guidelines
1. A move followed by a sideways range often precedes another move of almost equal extent in the same direction as the original move. Generally, when the second move from the sideways range has run its course, a counter move approaching the sideways range may be expected.
2. Reversal or resistance to a move is likely to be encountered:
On reaching levels at which in the past, the commodity has fluctuated for a considerable length of time within a narrow range
On approaching highs or lows
3.Watch for good buying or selling opportunities when trend lines are approached, especially on medium or dull volume. Be sure such a line has not been hugged or hit too frequently.
4. Watch for "crawling along" or repeated bumping of minor or major trend lines and prepare to see such trend lines broken.
5. Breaking of minor trend lines counter to the major trend gives most other important position taking signals. Positions can be taken or reversed on stop at such places.
6.Triangles of ether slope may mean either accumulation or distribution depending on other considerations although triangles are usually broken on the flat side.
7. Watch for volume climax, especially after a long move.
8. Don't count on gaps being closed unless you can distinguish between breakaway gaps, normal gaps and exhaustion gaps.
9. During a move, take or increase positions in the direction of the move at the market the morning following any one-day reversal, however slight the reversal may be, especially if volume declines on the reversal.
Donchian Channels Indicator
Donchian Channels measure volatility by placing bands at a specified period deviation. These bands are two standard deviations from the market price, so as the market price changes, the value of two standard deviations changes at the same time, the expanding and contracting of the bands based of course is based on recent price volatility.
Calculation of the bands is as follows:
Donchian Channel High = MAX (HI, n)
Donchian Channel Low = MAX (LO, n)
The Donchian Channel is a simple robust trend following breakout system and works well in trending markets. The signals derived from the Price Channel, are based on the following rules:
When price closes above the Donchian Channel, buy long and cover short positions.
When price closes below the Donchian Channel, sell short and liquidate long positions.
The Donchian Channel indicator is not meant to catch tops or bottoms and should only be used to identify trends. Trend traders may want to extend the standard 4 week period to 8 weeks in order to gain more accurate signals while on the other hand, traders may shorten the period to a more sensitive 1 or 2 weeks for liquidation and stop loss purposes.
Richard Donchain 4 Week Rule
The 4 week rule was developed by Richard Donchian in the seventies and will work in any trending market and is still as effective today as it was when it was first used.
The system only has one rule and here it is:
1. Close short positions and buy long whenever the price exceeds the highs of the previous 4 calendar weeks
2. Close long positions and sell short whenever the price falls below the lows of the previous 4 calendar weeks
The 4 Week Rule is a simple breakout trading system which always maintains a position in the market place and operates a SAR (stop and reverse) money management strategy.
When the market is not trending the above system will produce lots of false trading signals which can cause periods of sharp draw down. An effective solution to this problem and to restrict equity dips is to enter on the 4 week rule ( on the breakout), and to exit on a shorter time frame such as 1 or 2 week high or low or use a moving average to exit.
Richard Donchian a Personal View
For me, Richard Donchain is one of the best traders of all time and while many traders like to think that complex and clever currency trading strategies work best, my own view is that the simple strategies and trading guidelines which Donchian used are as effective today as they ever were. If you study his work and try his methods, you will see just how effective they are.