The Four LinesTrading System

Only systematic trading may be successful

Every textbook for beginners persuades you that trading must be only systematic, all
the rest is just a game.
But where can you find that system? Successful planning of operations and especially
creation of personal trading systems reuire good knowledge of technical analysis,
appropriate software tools and above all, your personal understanding of the nature of markets
and peculiarities of market!s behavior. "ne who makes his first steps on the market has a long
way to go.
#ere is the contradiction$ %o trade successfully you should have a high degree of
understanding of markets. But you can not understand market!s nature without trying to work
there and loosing money.
&nd here is the solution$ 't!s critically important for novice trader to have some very
simple but universal and reliable scheme for planning of his work from the first steps on
the market.
' propose such scheme that is based on the single indicator and includes very simple
but powerful statistical procedure for constructing reference lines generating trading signals.
RSI oscillator and its main properties
%o calculate (S' you should select some window that embraces ) candles of the chart.
Beginning from the first candle of this window, define the sign of change of this candle!s
closing price relatively to closing price of previous candle. 'f current candle has closed higher
than previous one then displacement value *current close minus close of previous candle+ is
summed with accumulated sum ,. 'f current candle has closed lower than previous one then
this displacement value *absolute value of closing prices! differences+ is summed with
accumulated sum -. .hen all candles within selected window are taken into account then ,
is eual to the sum of /up0 displacements of close prices within this window and - is eual to
the value of accumulated displacements /down0. %he value of (S' indicator is calculated as
(S' 1 233 , 4 *, 5 -+
and then it is printed on linear chart at the point corresponding to the right end of the window.
%hen this window is moved one candle right and all calculations are repeated.
%he range of (S' values is *3,233+6 (S' close to 233 corresponds to market actively
moving up6 in falling market (S' values are close to 7ero. 8alues about 93 show neutral
market. 'f the market stays in the area of high (S' values for a long time then it is considered
to be overbought, i.e. prices are likely too high and it is possible that market will turn down
soon. (S' value :3 is usually considered as the sign of overbought market.
'n the same way the market that for a long time stays in the area of low (S' values is
considered to be oversold; prices are too low and it!s possible that the market will turn up
soon. <enerally accepted threshold value for oversold condition is =3.
Besides overbought and oversold areas, divergence is also considered as reliable
signal indicated by (S'. %he typical configuration when price chart reaches new maximum
higher than previous one and (S' shows maximum that is lower than previous one is called
divergence. Such divergence marked as div2 on FIGURE 1 forecasts some down move of
the chart and it is called bearish divergence. 'f divergence appears after the
>igure 2. -ivergences and overbought4oversold levels *(S'*?+,
hourly spot British @ound, 2= A B? )ov B333+
chart made down movement6 the price reaches new lower minimum and (S' shows minimum
that is higher than previous *divB and div= on FIGURE 1+ then such divergence is called
bullish divergence and it forecasts market!s bullish upturn. -ivergences give reliable signals
if they are formed while indicator is in overCbought and overCsold areas, or at least in close
proximity to them.
The idea of the Four Lines
Standard recommendation for using of (S' *as well as of many other oscillators+ in
trading is to sell when (S' leaves overbought area and to buy when it leaves oversold area.
But practical application of this recommendation shows that thus generated trading signals are
not reliable; after overbought4oversold levels are broken, the price chart freuently goes back
in opposite direction so the percentage of positions resulted with losses is too high.
,sual approach to improve the (S'Cbased trade system consists in introduction of
some additional indicators into enter4exit rules *for example, buy when (S' leaves oversold
area if some trending indicator shows bullish market etc+. But more complicated system is not
inevitably more efficient and in any case it is very important for beginner to have trading
approach which is as simple as possible. 't is clearly much easier to test and analy7e the
trading plan based on the single indicator than to deal with the set of indicators$ So let!s try to
understand why such indicator of proved worth as (S' with such highly reliable reference
lines as overbought4oversold levels very often leads to losses? &ttentive look at the chart
shows the answer immediately; the levels :3 and =3 were selected for all charts in general and
for all situations in average. But as a matter of a fact even the certain market in different time
periods can form uite different levels6 these levels are changing with time and they are
different for different markets.
Darkets are too complex to obey to predetermined reference levels. 't is necessary to
define those levels for each specific market. &nd this turns out to be easy because the market
itself prompts where those levels have to be located. Eook, for example, on typical
configuration of (S' on the hourly chart of the British pound, FIGURE 2 *Fan =3 A Darch 32
B332+. #ere we can observe some range *between two inner lines+ where indicator!s values
are changed for a most period of time. >rom above and from below the whole range of (S' is
limited with two parallel lines that have some slope relatively to hori7ontal axis. So we have
four parallel consolidation lines; the two extreme lines *upper line and lower line+ represent
upper and lower bounds of indicator!s chart and two inner lines (turning lines: overbought
line and oversold line) are drawn through the areas where (S' shows either up or down
turns.
>igure B. %he four lines on the hourly chart of the British pound,
Fan =3 A Darch 32 B332.
%wo extreme lines limit the range of (S' values and they can significantly differ from
233 and 3, besides, typically they are not hori7ontal but usually have some slope. %his slope
of the boundaries of (S'!s range is valuable information by itself because it indicates certain
changes having place inside the market. (ange boundaries sometimes can be directed
downward when the market consistently goes upward or vice versa. 't means that there is
something happening inside the market which have not yet revealed itself in price movements
but it will certainly show itself later.
%he internal consolidation lines on the (S' chart are drawn parallel to the extreme
lines and placed in such a manner that many (S' turnovers look as reflections from those
lines *down or up+. "f course, it!s necessary to be enough flexible while drawing inner lines.
%he bearings of extreme lines are the peaks or lows of (S' and they are clearly visible. But
inner lines go through the areas of consolidations of reversal points of (S'. 't may seem not
so obvious to find these areas. But you!ll reali7e very soon that such areas always exist; the
indicator likes to form turning points in the neighborhood of perfectly expressed lines. &fter
several attempts you will get sufficient experience to draw these four lines and you!ll be able
to find them very easily and naturally.
How to plot the Four Lines
'n brief, algorithm of drawing the four lines consists of the following steps; display the
chart over sufficient period of time and draw the straight line through extremes of (S' chart
*select the line that in the best way fits extreme points A either minimums or maximums+.
&fter such extreme line is drawn, draw parallel line through opposite extreme points.
'ndicator!s extremes sometimes do not fit the straight line well. %he situations when adeuate
four lines can not be selected are possible in chart!s life. But it happens very rarely. 'n most
cases you will find good extreme line without problems. .ill it be maximums! or minimums!
line, from my point of view, is of no importance. Gou should take the line that better fits the
chart.
>igure =. Danually drawn four lines A upper chart of (S'*?+, mechanically drawn
four lines *Standard Error Hhannel with parameters B.3 and 2.=+ A lower chart of (S'6
hourly British pound, B= )ov A B9 -ec B333 I.
#aving extreme lines drawn, you!ll almost never meet any problem in drawing
turnover lines *overbought4oversold lines+; find consolidation areas for turning points of (S'
chart and draw the straight line parallel to extreme lines through them.
't!s clearly visible *see FIGURE 3+ that downCmoves of the market start not from
standard overbought level :3 but from the upper inner line. 'n the same way, upCmoves start
when (S' upturns not from =3 *or another fixed level+ but from the level the sloped lower
inner line has led to. 'n other words, the market dictates what lines *not levels but lines$+
should be considered as references for overbought and oversold states of the market.
Sometimes you will find that internal lines are not located at the same distance from
their extreme lines *in usual understanding of overbought4oversold levels it would correspond
to nonsymmetrical levels; not :34=3 but, for example, :34B3+. %his asymmetry of overbought
and oversold areas points to something interesting in market sentiment and this also may
provide some useful additional information.
%his informal algorithm of constructing the four lines is in the reality some statistical
procedure; the >our Eines arise as the result of nontrivial statistical analysis of market!s
behavior. &nd if you have any difficulties in drawing of lines or my explanation seems not
enough transparent A there is very effective and universal statistical method of drawing the
four lines. &pply the Standard Error Hhannel function to the (S' chart *' use the notation of
function from the DetaStock but similar function is also included to each other technical
analysis software+. %his function calculates and plots regression line within selected period of
time and plots two parallel lines above and below the regression line at the distances
proportional to standard deviation calculated relatively to the regression line.
%ake the parameter of Standard Error Hhannel function eual to B.3 then the upper and
lower lines will correspond to extreme lines of the >our Eines System *the probability of the
event /(S' lies above upper line or below lower line0 is less than 3.39+. %hen apply this
function with parameter 2.3 and get two parallel lines at the distance of one standard deviation
from the regression line *it corresponds to 3.JK probability for indicator to take values inside
the area between two inner lines+.
/Danual0 graphing of four lines allows you to stress some individual features in
market behavior and to adjust lines with regard for your personal attitude to the market, but
/mechanical0 procedure is more objective and formal, furthermore it is easier for beginners.
&ny trader oneself will select the best method to use. &fter certain training the /manual0
drawing of lines also becomes easy and comparing the results with /mechanical0 lines you
will be admired what a powerful statistical analy7er you have in your hands now.
,sually ' draw the four lines on hourly charts of currencies over the period of about 9
C J weeks, and then ' fix and use the lines in trading during a week ahead.
Trading rules of the Four Lines
%he areas in (S' chart between inner lines and extreme lines may be considered as
designating overCbought and overCsold states of the market, but what we have now is not
levels but lines
>igure K. >our examples of continuation signals6
hourly Fapanese yen, Dar B: A =3, B332
%he >our Eines can be directly used as /enter0 signals in opening of positions; when
the indicator leaves overbought area and crosses overbought line from above it!s a signal for
you to open the short position, and when indicator crosses oversold line from below open long
position. %he application of successfully drawn four lines in trade can give somewhat better
results than standard fixed levels *e.g. :34=3+, but it is not the only thing we can obtain from
this geometry.
>irst of all, it turns out that entering of RSI to the overbought/oversold area is also
good reference for opening of positions and what is more it works often and reliably. So '
include it in my system as one of trading ideas. Such signals are useful for opening positions
on trending market *FIGURE 4+.
>urther, it is well known that after the breach of trend line the price chart tends to
begin rally. 't is one of principal properties of market charts. But not every breach gives good
trade signal. So ' recogni7e any trend line on price chart as reference line for opening
position but ' am not ready to trade every trend line because ' want to get additional
information.
&s well as the breach of trend on price chart, trend breakout on indicator chart gives a
good signal of market!s move. Breakout of a strong line on (S' chart freuently forecasts
some strong move of the price chart. So ' take trend line on (S' chart also as reference line.
>igure 9. >our examples of trading signals6 hourly chart
of the British pound, Darch 39 A 3?, B332
%he combination of two reference lines gives me the trading signal; ' open position
when the (S' chart crosses it!s trend line and then *or simultaneously+ the price chart shows
the breach of it!s own trend line. 't is exactly this rule that ' adopt as the main trading rule of
the Four Lines. ' consider this rule as universal within the frames of the system; each
reference found on (S' should be confirmed by the related reference on the price chart.
%he FIGURE 5 shows four examples of signals to open positions according to the
main rule. %he pair of descending trend lines 2 was formed on price and (S' charts and the
breach of (S'!s trend *dashed vertical line Darch 3J, :<D%+ was confirmed with the breach
of the price trend line after closing hourly candle. %he long position should be opened on the
next hour.
%hen two ascending trend lines B were formed on the price chart and on the indicator.
&fter the (S'!s trend B was crossed *dashed vertical line Darch 3:, L<D%+ and so was the
price trend line B on the next hour, the short position was opened.
%he breach of oversold line *green arrow, Darch 3:, 2L<D%+ was followed with the
breakthrough of descending price trend = on the next hour *the buy signal+. %he fourth signal
was generated by simultaneous breach of (S'!s trend K and of related price trend line K
*Darch 3?, L<D%+.
Gou can easily make sure that when (S' breaks through some strong trend line there is
always an appropriate reference line on the price chart. Such combination of reference lines
for opening of position is the mostly corresponding to the main property of market charts;
after chart breaks through strong consolidation line, the strong move follows. %he indicator
shows the direction of maret sentiment6 indicator crossing the reference line marks an
essential change in sentiment, and price chart crossing its related trend *or level+ confirms
possibility of significant move in that direction. Such situations represent the best
opportunities to open position.
>igure J. Horrect *2, =, 9+ and incorrect *B, K+ references
on the hourly Fapanese yen, Dar J A 2B, B332
Dy long practice of using these trading rules has prompted the useful reference
selection condition; the trend line on (S' chart must rest on extreme points residing in
different ranges of indicator values *see FIGURE 6). 'f initial point of the trend lies within
the overbought area, the following point through which descending trend is drawn must lie in
the middle range of four lines system *between two inner lines+. 'f ascending trend on (S'
chart begins from local minimum in oversold area, the second local minimum through which
the trend line is drawn must be in the middle area. %rend lines beginning in the middle area or
lines with both bearing points belonging to the same extreme area are better not to be
considered. %his rule of selection helps to reject many false price movements that otherwise
could generate losing positions.
Additional reference lines for trades
%he main rule of the >our Eines System gives the signals reliable enough for opening
of positions. But there is some shortcoming that is relatively small number of positions. >or
example, on the hourly charts of main currencies sometimes you should wait about two days
before the signal occurs. 'n most cases it proves to be the best way of action; to wait for the
most reliable signal. )onetheless some trading opportunities on clearly visible price
movement may be lost.
%herefore ' use some patterns freuently formed on market charts as additional
references for trades.
%he first of such patterns is divergence of (S'. %he following rule naturally arises
within the scope of the >our Eines; the line that defines divergence on the indicator chart must
start from the extreme point in overbought or oversold area.
%he fan pattern is mentioned in all textbooks of technical analysis as reliable reversal
pattern appearing in slowing market movements. "ne example of the fan is shown on
FIGURE 7. #ere the hourly chart of Fapanese yen has formed descending trend *the first ray
of the fan+. &fter this trend was broken the chart showed upside correction but then the down
move renewed and the second ray of the fan appeared. &fter breakout of the second ray the
chart has shown the beginning of new bearish trend which is the third ray of the fan.
!reaout of the third ra" of fan is considered as reliable signal of the end of trend *bearish
in this case+ and gives the reliable signal to open long position.
>igure :. %he fan on the hourly chart of Fapanese yen *2: Fan A ? >eb B332+
' want to stress that breach of fan!s third ray is the signal by itself even without related
reference line on (S'. Such situation took place on the >igure B where breakout of trend line 9
was not followed with appropriate reference on (S'. Such signal *the third ray of fan+ may be
very useful in such situation when for a long time you can not find the correct pair of
reference lines to apply the main rule.
>igure ?. %he folding rule on the hourly chart of Fapanese yen
*&pr B3 A Day 3=, B332+6 three sell signals
#he folding rule discovered and described in the paper from Fune B332 issue of
StocksMHommodities is another reversal pattern that may be naturally introduced to the >our
Eines. .hile the fan is formed on slowing trends the folding rule appears on accelerating
markets and gives reliable signals of trend reversals *FIGURE 8). ,sing of the folding rule
is analogous to that of fan; breakout of the third ray gives trading signal *even when it is not
confirmed with the related reference line on indicator!s chart+. &fter the third ray is broken
*that confirmes the whole folding rule pattern+, the continuation of its second ray becomes a
strong consolidation line. %he crossing of this line generates new trading signal. Dy
observations show that continuation of the first ray is also reliable reference for opening of
position .
#he Four Lines #rading S"stem
)ow ' want to formulate the set of rules that compose my version of the Four Lines
#rading S"stem.
2. %he main trading rule: the (S' chart crosses trend line and then *or
simultaneously+ the price chart breaks related trend line in the same direction. %he (S'!s
trend line should obey the reference selection condition: its first bearing point must be in
overbought4oversold area and its second bearing point lies between inner lines.
B. Fan and folding rule; when the price chart breaks the third ray of fan or
folding rule open position in that direction. 'f the third ray of the folding rule was
successfully breached its second and first rays become references for opening of positions.
)ote that breakouts of all these rays represent trading signals without confirmation
*indicator!s reference line is not necessary here+.
=. $ivergence is the trade signal in usual sense.
K. Indicator enters overbought or oversold area *i.e. indicator!s chart crosses
corresponding inner line leaving the inner area+ and the price chart breaks some trend line.
9. Indicator leaves overbought or oversold area *i.e. indicator!s chart crosses
corresponding inner line and goes to inner area+ and the price chart breaks some trend
line.
%hese five rules for opening of positions compose the core of the trading system. %heir
enumeration reflects typical freuencies of these rules in trading; the rule 2 has the highest
percentage of positions opened after such signal, the rules B A = often change their places in
this ordering but the rules K and 9 almost always have the lowest freuencies.
Gou remember that the idea of the system takes its rise in the rule 9 but in reality this
rule works rather seldom. Gou!ll see the reason while applying the system; after (S' crosses
the inner line you must find the reference line on the price chart. 'f appropriate reference on
the price chart does not exist then the possibility of opening position is missed. 'n the course
of time some good reference line on the price chart will appear but related (S'!s reference
will turn out to be the trend line but not the overbought4oversold level. &nd it gives the signal
of type 2.
't is easy to add more rules to the system if you have good trading ideas that may be
expressed in terms of the >our Eines. 8erify them by statistics on historic charts and use in
your trading. >or example, if you are risky trader you may probably like the rule of
indicator%s outliers; to sell when (S' has formed maximum above the upper line and to buy
when (S' has formed minimum below the lower line. %he way of drawing the extreme lines
guarantees the exceptional character of the outliers so with high probability they predict
reversal points of the market. But you must understand the risky character of such signals and
apply them carefully.
%he complete definition of trading system should also include rules of placing the
protective orders *stopCloss+ and rules for control of opened positions *placing of stopCtrade
and takeCprofit orders+. ' do not define here the set of such rules exactly because it depends on
each trader!s capital and on his targets of trading while the purpose of this article is to
introduce the general concepts of the >our Eines %rading System. &dd these money
management rules and get the complete definition of your personal trading system, then begin
its testing on your historic charts.
#he Four Lines #rading S"stem: Some e&amples of trading signals
%he FIGURE 9 explains the way of application above formulated rules. %he trend
line & on (S' is incorrect reference according to reference selection condition: both its
bearing points *local minimums+ lie in the inner area between oversold and overbought lines.
So the simultaneous breach of line & and of price trend line B is not considered as trade
signal. @enetration of (S' from inner area to overbought area *marked by vertical blue line
&pr 2J, 2B <D%+ coincided with breakout of trend line 2, it is buy signal according to the
main rule *type 2+. %wo pairs of trend lines B, = and -, K also represent type 2 signals6 initial
points of lines B, - are located in the high area of (S' while another bearing points lie in the
inner area. Breakthrough of level 9 coincided with new penetration of (S' to overbought area
*marked with green arrow+ is buy signal of type K. But subseuent breach *vertical line &pr
2?, 2K <D%+ of line H and of level 2.:K93 *resistance level A high of &pril K+ is not correct
signal because line H is drawn through two points in the overbought area.
(eturning of (S' into inner area *red arrow+ and breach of price trend line denoted as
the second ray of fan *B>an+ is the sell signal of type 9. %his event coincided with breakout of
(S' trend line E but this line is incorrectly drawn through points in inner area so it can not be
considered as type 2 signal.
>igure L. %rading signals of the >our Eines on hourly Swiss frank, &pr 2= A 2L, B332
Breakout of the third line of fan *=>an+ is sell signal although it is not confirmed with
any (S' reference. %he last sell signal *&pr 2L, 2L <D%+ arises due to (S' entering the
oversold area followed with breakout of support level J *low of &pril 2:+.
>igure 23. Examples of the >our Eines trading signals on hourly chart
of Fapanese yen *Darch 2L A BL, B332+
Dore examples of signals for opening positions are presented on FIGURE 10 *hourly
chart of Fapanese yen, Darch 2L A BL, B332+ with earlier drawn system of four lines. %he
arrows on the (S' chart point to the signals generated by crossings of inner lines *(S' leaves
extreme area and goes to inner area+. 'f such crossing is confirmed by breakthrough of related
trend *reference line+ on the price chart then position should be opened in the direction of the
arrow *it is opening rule of type 9+.
(eference lines for long positions are highlighted in green and reference lines for short
positions are in red. Such reference line may be a trend line or a consolidation level;
resistance *green+ or support *red+. )umbers accompanying the price reference lines denote
the types of opening signals according to aboveCmentioned classification *two divergences are
also shown by blue lines on price and (S'+. %hin lines show possible placement of stopCloss
orders for each position.
&s you can see trading signals of the >our Eines System have detected all valuable
reversal points for this market moving in uite a narrow range. 'n general, according to my
statistics obtained by testing on the hourly charts the signals appear with average freuency of
no less than one signal every day at each of the four main currencies *British pound, Euro,
Fapanese yen and Swiss frank vs. ,S dollar+.
>igure 22. 'nitial configuration for trading with the >our Eines *hourly chart
of British pound, "ct =3 A -ec 22, B333+. Danually drawing *lower chart of (S'?+
four lines in comparison with mechanically computed lines *upper chart of (S'?+
%wo last pictures give a model of application of the >our Eines System in real trading.
%he FIGURE 11 represents the process of drawing the four lines at hourly chart of British
pound *)ov A -ec B333 period of about : weeks+. Gou may compare the results of manual
drawing *lower chart of (S'?+ of four lines and mechanically computed Standard Error
Hhannels with scattering parameters B and 2 *upper chart of the same (S'?+.
%rading signals generated by these Eines during : days in -ecember B333 are
presented by FIGURE 126 some of them were used in real trading. Everybody who traded
>"(EN those days remembers that this was not an easy trade$ Gou hardly may consider this
market *FIGURE 12+ as trending but it also does not impress as the channel. &ny intraCday
trading system would meet problems in this situation. &nd you can see how the >our Eines
worked there.
>igure 2B. %rading signals of the >our Eines %rading System on hourly chart
of British pound *-ec 2= A BB, B333+
't is clearly visible from these examples that the >our Eines System gives timely
signals related to price movements and you may easily fulfill their statistical verification and
compose your personal variant of trading system based on the >our Eines.
Conclusion
%here is nothing new in the statement that only systematic trading on financial markets
has chances to be successful. .hen your trading is based only on hopes for success and you
lose the money, it means only that now you have less money and nothing more. But if you
trade according wrong system then you have chances to correct it and find your own correct
system. Eosses you incurred in such situation are a kind of the payment for good approach to
trade found finally. &nd good approach to trading on financial markets is worth of any
money.
%he >our Eines trading system is some kind of window through which any trader may
observe the market from his first steps in trading. %he >our Eines represent a simple approach
derived from the basic principles of technical analysis so it may be recommended for
beginners.
' have verified this approach on hourly charts of the main currencies and find it
enough reliable and efficient to propose it for intraCday >"(EN traders. )o doubt the
approach can be used not only on >"(EN but also on the other markets and on different time
frames.
Related reading
Eikhovidov, 8iktor OB332P. /%he >olding (ule0 Technical Analysis of
S%"HQSMH"DD"-'%'ES, 8olume 2L; Fune.
Eikhovidov, 8. OB33BP. / %he >our Eines %rading System,0 Technical Analysis of
S%"HQS M H"DD"-'%'ES, 8olume B3; Fanuary