Filters

Filters are conditions that are introduced into a set of trading rules in order to smooth, or help correct, violations. They are purely a set of additional rules that have been established by Technical Analysts over generations which help to rule out violations, and establish correct trending moves.

Violations? What are they again? To recap, violations are incidents where prices sit on the moving average line and do not completely cross it in their entirety. This creates problems when attempting to trade using a MA line because violations can create incorrect trading signals if you don’t understand how to deal with them. Since the most commonly used filter for a MA is the closing price filter, we shall look at this filter first. This filter requires that price must close across the MA line at the end of the day, and any intraday MA crosses will be ignored. A trading example of this has been provided below:

A list of other filters that are commonly used include:

Close – Price must close across the moving average

(Two-day closing price filter – Two days closing prices must close across the line)

Percentage – Price must cross the MA according to a particular percentage of the price or relative to the moving average

Price – Price must cross the MA by a specific number of price units

Entire Bar – The entire price movement must be on the other side of the moving average

Time – Price must cross the MA for a particular time period

Another, more complex filter that deserves some comment is the Directional Filter which analyses the MA according to the direction of the MA line. This implies that we must go long when the MA line is moving upwards, and short when the MA line is moving downwards. In saying this, it is important to understand that these rules only apply when used in conjunction with the movement of price across the MA line. Thus, a typically trading strategy to use incorporating the directional filter, would be to go long when the MA line is rising and price crosses the line from below to above. This position would then be closed if the opposite occurred, namely the price moved from above to below the line and the MA line was falling. This would then be a typical signal to open a short position.

In summary, the Directional Filter is used in the following ways:

Directional Filter – Traders are only entered according to the slope of the moving

average and direction of the trade. Therefore:

• Go long when price crosses the rising MA line from below
  • Reverse the position when price reverses from above to below
• Go short when price crosses the falling MA from above
  • Reverse the position when price reverses from below to above

It is important to remember when using filters that they are not to be used by themselves as a trading indicator, but rather as a medium to assist in identifying plausible trading opportunities and rule out false ones.