Traders are fond of creating complex systems composed of sophisticated technical indicators, but novice traders often neglect a solid system's key component: the filter. A system's filter limits the trader's exposure to risk while still allowing the system to provide a satisfying number of signals. As such, a filter, coupled with sound money management, can tilt the odds in the trader's favor in the long term.
One type of filter utilized by many traders consists of a simple moving average set to 100 periods or more. At this periodicity, the moving average presents extreme lag and thus provides a ready indication of the price's long-term trend.
If, for instance, the 100 period moving average is above the price and the trader's system produced a buy signal, the trader would disregard said signal. This is because with the price floating below such a long term moving average, the trader can be sure that it is, or has been very recently, trending down. It is therefore likely that a buy signal generated in such circumstances would produce a failed trade.
There are two primary types of filter: traditional technical indicators, such as the moving average and MACD, and indicators that interpret volume data. A trader can use any lagging indicator as a filter provided that it illuminates the long term trend. Non-lagging indicators such as the Renko and candlestick signals can be of use so long as the trader is sufficiently versed in them. These filters often complicate matters, however, as they are complete systems unto themselves.
Indicators that interpret volume data, such as the Market Facilitation Index, Acceleration Bands or Accumulation Distribution, can be particularly useful as filters as they illuminate underlying factors that traditional technical indicators cannot show, such as moment-by-moment consolidation.
It is important to note, however, that filters do not increase a system's accuracy. They merely provide an 'opinion' on the system's signal. If the trader takes the filter's recommendations faithfully, the net result will be that fewer trades take place over time. With a good system, more of the trades that are taken will be winners rather than losers. Moreover, if the trader is practicing sound money management, they will enjoy a definite advantage over their counterparts who are not using a filter.
For instance, if a trader as a rule always closes a trade either in profit of 20 pips or a loss of -10 pips, they need only secure the former two times out of five to achieve an aggregate profit. A simple filter that can prevent them from trading against the trend-a common cause of losing trades-can improve profitability by culling some of the losers, and improving the ratio of good trades to bad.
Traders deploy different types of filters depending on the particular signal their system generates. A system that utilizes the MACD as its signal generator, operating on the 15 minute time frame, would see benefit from a filter composed of the same MACD indicator but operating on the 4-hour time frame. The second instance of the MACD is taking a wider view of the market, and it can alert the trader to changes in the longer term trend that would undermine their trade.
Essentially, a good filter causes the chart technician to become aware of a wider flow of data. It can be very tempting to a take a well-tested system's signal at face value, but doing so is an unnecessary risk that can cost equity in the long run.