by Jea Yu

As I developed as a trader, making the right transition from consistent loser to consistent winner, I began to look for reasons why I should not be trading.  I looked for red flags that told me my setup had less of a chance of working.  This is the opposite of what beginning traders or traders who have developed bad habits seem to do.

I refer to the increasing number of trades placed by a marginal trader as the “smart trader curve”.  In the very beginning, we learn that it is so difficult to become a profitable trader; the market is against us.  We are cautious, maybe even afraid to pull the trigger.  We just don’t want to be wrong, especially when we know we don’t know.

Slowly we become educated.  We buy books and learn the author’s “sure fire” technique that lets him or her win in the “Great Trader All Star Game,” and turn $10,000 into $1,000,000 in three months.  When we start losing, we add the “sure fire” method to our arsenal and trade that.  In three months we do not have a million, but we do have three more trading systems under our belt.  When we start the day, we patiently watch our charts, and pretty soon one of the Holy Grail patterns emerges.  We jump on it.  We might be aware that the market action is almost showing another “magic bullet” trade that indicates a trade in the opposite direction of “sure fire”, but “sure fire” fired first, so we took it.  And if the trade goes against us right away, we really feel the pressure of a “magic bullet” almost telling us over our shoulder that we should be in the opposite position.  Is it any wonder that as soon as the trade starts working we are quick to jump out with a little more than a surplus after covering commission costs?

The Filters are designed to trade less, not more.

The Filters are composed of:

Filter 1, The 15-Minute Trend: The general direction of the market’s price.  Just place a simple 15-minute candlestick chart with a simple moving average.  We like to use a 5-period moving average and a 20-period moving average.  If the 5-period has crossed above the 20-period we conclude that the trend is up.  The trend is down when the 5-period is below the 20-period.  The 15-minute trend produces the largest weighting in our Filters indicator.

Filter 2, The Daily Pivot: Floor trader daily pivot points are levels at which the market may change direction.  They are derived by calculating the numerical average of a particular stock’s high, low, and closing prices.  Pivots are available in most every charting platform available today.  The reason pivot points are so popular is that they are predictive as opposed to lagging.  Because so many traders follow pivot points, you will often find that the market reacts at these levels.  This gives you an opportunity to trade.  If the current market price is below the daily pivot, then we are bearish on this filter, if above, we are bullish.

Filter 3, Advance/Decline Index: A technical analysis tool that represents the total difference between the number of advancing and declining security prices.  This index is considered one of the best indicators of market movements as a whole.  Stock indexes such as the Dow Jones Industrial Average only tell us the strength of 30 stocks, whereas the advance/decline index can provide much more insight into the movements of the market.  We look at the current advance/decline index number as well as the trend of the advances/declines to determine a bullish or bearish bias.  For example, if the advance/decline was -835 and falling, our bias would be bearish.  If the advance/decline was 568 and rising, our bias would be bullish.  When the advance/decline is between -300 and +300, it normally means the market is in an undecided chop zone.  Be careful in this range.

Filter 4, Stochastics: We placed a stochastics indicator on a 3-minute chart.  There are times when all three of the above indicators align.  If we just monitored those indicators, the strength of the Filter would many times approach 100%, and that reading would imply that a trader could just buy or short at the market and open up the cash register.  We needed a way to try to help the Filter indicate that a trader might be chasing a move.  The 3-minute stochastics does just that.  If all the other indicators suggest a strong bullish move, then when the 3-minute stochastics rises above 50%, it begins to weigh that the percentage of success of the Filters is reduced.  The percentage would increase when the reading of the 3-minute stochastics indicates an opposite move has developed on a larger time frame.

Let me comment on the weightings of the components of the filters.  The exact numbers are proprietary.  Before you jump up and down and finally feel that I am giving in to the notion of a Holy Grail, let me assure you that the only reason I have plugged numbers into the mix at all is to let a computer produce an output.  Unlike humans, computers have a little problem with an instruction like “paint a blue bar if the market looks strong”.  The computer would answer with a snotty question similar to the movie The Coneheads; “Please define strong”.

So we have to pick a 5-period moving average and a 20-period, just because lots of people like the 5 and the 20.  Yes, many also like the 3- and 50-period, so you can try that.  It would be a good exercise for a trader who wants to try plugging in different combinations and criteria for weights and variables.