Trade opening filters

Trade opening filters

trade opening filter

To have a complete trading system you need trade open criteria, entry method, initial stop loss placement, trade management plan, positing sizing method. For a complete trading plan, you need to add list of markets, broker, computer, trading hours, mental preparation, emergency plan, etc.

This article talks about one component of the trading system, i.e. filters you can use to decide if to open a trade.

Filters

Filters are criteria that needs to be met for you to open a trade. This is a list of things that, if not met, you do not open a trade. A good filter will eliminate losing trades. It will also occasionally eliminate a wining trade; that’s trading.

Possible filters to use

  • trend, i.e. simply the trend on the timeframe you trade. If there is a clear uptrend, you take long setups only. Or maybe you trade the system only if there is a clear trend.
  • higher timeframe trend, e.g. if your primary trading timeframe is H1 (i.e. primary TF where you look for setups and you look at the chart every hour), then likely your higher level TF will be daily D1 or H4. So, a trend on your higher level TF can be a filter, i.e. if the trend is UP, you take long trades only. If the higher TF trend is DOWN, you take short trades only on your primary TF. This is what dr Alex Elder says in his books.
  • how to define a trend – here is a number of ways:
    • judgemental, i.e. you look at the chart to tell if it is going up, or down, or unclear (if unclear you do not trade it OR use a trading system designed for range trading)
    • using the indicators, e.g. if EMA 13 is above EMA 26 (or any other combination such as 9,21 or 100, 150, or 150, 365, all depending on your TF), OR MACD histogram OR combination, e.g. if both EMA 13 above EMA 26 AND MACD histogram up, then define it an uptrend)
    • using high and lows, i.e. define the uptrend by higher highs and higher lows and downtrend by lower highs and lower lows. Define a “high” or “low” (or call it swing high or low) by a bar pattern. “High” is where two bars before and two bars after the bar are lower, also known as fractal. “low” is where two bars before and two bars after the “low” are higher, i.e. fractal.
    • using a trendline, i.e. draw a trendline, for uptrend using at least last two swing lows, for downtrend using last two swing highs. This is judgemental.
    • using a supply & demand analysis, i.e. if previous demand levels are being taken out, then we are in a downtrend. If previous supply levels are being taken out, we are in an uptrend
    • any other way that makes sense to you.
  • market type. What market are we in? Is this a good market for this trading system? Van Tharp in his books and newsletters says there are 6 market types. bullish / bearish / neutral and normal / volatile (6 combinations). You may identify more or less types. Also different pairs look differently. Have a look at the chart and assess if this market is “friendly” for a given method. e.g. if you see a ranging chart, then it is likely not good for trend following, but may be a good market for some range trading systems. If you see a very clear trend, look for a system that will look for value zone locations to safely join the trend at a correction end.
  • the market, i.e. simply which currency pair or index or commodity or interest rate or stock or whatever tradeable market this is. Simply some systems are better for some markets than others.
  • time of the day, in case you have backtested a specific day trading system, you may have noticed it works well in certain time of the day when there is volatility, or it may exploit a certain time-based characteristic of the Asian session, or a London close. If your system is time-sensitive, then obviously a time of the day becomes a filter. If you have the system to follow the morning breakout of the London session, do not trade it in the evening, and so on. The same idea may apply to days of the week, e.g. do not trade on Mondays, etc.
  • news – or better a lack of big planned news releases, many day traders avoid trading if there is an upcoming big news event. “big” often defined as red item in the forex factory calendar. So a lack of news becoms a filter. Also, right before, during and after the news release, the spreads are often higher, which is a bad thing.
  • sentiment – bullish or bearish
    • broker’s sentiment index
    • info from the analyst you trust or your broker
    • Commitment of traders data on myfxbook
    • your own assessment of the sentiment based on how the market reacts to news:
      • e.g. if the market ignores the bad news and goes up on good news, then you may say there is a bullish sentiment. Reverse for bearish
  • R ratio TP level “available” before key S/R. For example, you want to go long, your logical place for initial stop is 20 pips below the market, so if you want to get at least 2R TP, you need to aim for 40 pips. But what if there is a major resistance 35 pips above, before your TP level? This may be a reason to pass on this trade, because the market is likely to reverse just before your TP.
  • behavior of some other market. I explored this a bit in my post about trade opening, but it also can act as a filter, e.g. you go long an individual stock only if the stock index is in an uptrend. Or look at the U.S. dollar index before trading any USD-based pair.
  • your mental state – are you relaxed, focused, good and positive? or distracted, stressed, feel like need a revenge on the market, feel like ego is at stake and need to make money fast? Yes, the former is the good mindset and a mental state to trade. The latter is a big NO GO to putting money on the line.
  • almost any other criteria – same as ones you use for trade opening setup
  • anything else that works for you – and what works we need to learn by backtesting, forward testing and live trading experiences…
  • and last but definitely not least – the fundamentals, i.e. your macro view on the economy, your or the analyst you trust. Application of fundamental analysis is a big topic in itself, and while not necessary for everyone, it may be a great filter for pro trades for higher timeframes.
  • and one more related to fundamental analysis: the interest rates differential and its impact on swap points (roll-over rate), important if you intend to keep the position long term, rollover rate will impact your trade result positively if you go long the pair with a higher interest rate and short the pair with the low interest rate (a famous carry trade).  This may be a filter, too.

Note that you can decide to use zero, one or more filters. Backtesting is the way to tell if a given filter is a good thing. The more filters you add the less trades you will take. Question is, and you need to answer while backtesting, how it impacts the overall profitability.

See my other articles with a trading system label to learn about other building blocks of the complete trading system.