Directional
Day Filter
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Directional
Day Filter
Think about your day trading activities for a moment.
The profits were exciting, rewarding.
The losses were awful.
More winners would be great.
But, fewer losers can truly turn your day trading
into the profitable enterprise which you first envisioned
when you entered the world of the active day trader.
The often quoted trading axiom, "Let your
profits run and cut your losses short", is
as accurate and worthy of your attention as the
day it was first written by someone long ago. But
now let’s add another concept to this basic idea
of trading.
Imagine what your bottom line could look like if
you had an accurate method of reducing your number
of losses by even 15 – 20%.
One of the purposes of this book is to teach you
to significantly increase the number of winning
trades executed each trading day. Here is where
we start this important process.
Trading only in the direction of the dominant trend
for the day can significantly reduce the number
of losing trades that are taken during the course
of your busy trading day.
The Directional Day Filter is designed to accomplish
this exact purpose – define the major trend of the
day early enough in the trading day to make this
determination useful for the majority of the trading
session.
Operating
Theory
Look at the intraday price chart of any contract
or security, concentrating on the early portion
of each trading day. Observe the occurrence of the
highs and lows that are registered during this early
time frame. Regular observation of intraday price
charts will soon reveal the fact that, quite often,
the high or the low of the day is established early
in the trading session, often within the first 60
to 90 minutes of the day. This basic fact of market
behavior is the basis for the operation of the Directional
Day Filter.
It is here that market psychology enters into the
performance of this trading tool.
For a stock or commodity to trade higher for the
rest of the day there obviously must be more buyers
than sellers. As the trading public reacts to positive
fundamental news concerning the issue in question,
interest rate movements, government reports, earnings
news, or the myriad of additional factors which
make up the fundamental picture which effects the
price of a stock, a buying interest develops early
in the day. Buying activity in a stock or commodity
soon attracts more interest on the buy side as others
become aware of the news and either enter new long
positions or rush to cover their short interests
in the face of a rising market. And, yes, technical
traders such as ourselves enter on the buy side
due to the technical factors which identify a rising
market.
Since the basic fundamental news concerning a stock
rarely changes through the trading day, the same
fundamental factors will continue to spur buying
activity during the day.
The Directional Day Filter measures this buying
activity and predicts the basic trend of the day.
This filter is a highly effective, yet simple routine
that is used during the initial portion of the trading
day to define the major trend of the current day.
Properly interpreted, the Directional Day Filter
can determine, with a high degree of accuracy, the
trend for the remaining portion of the trading day.
After mastering the interpretation of this simple
concept, you will be able to accurately predict
an uptrending day, a downtrending day, or a sideways,
trendless day.
As with many trading indicators, their accurate
interpretation is frequently as much of an art as
it is a science. It is only after careful, extensive
observation and study that most traders become familiar
and comfortable with an indicator such as this to
the extent that they have the confidence necessary
to use them in actual trading situations. Carefully
study the following pages, as this indicator can
be a very powerful tool to assist you in your intraday,
and eventually, overnight trading.
We will first concentrate on a detailed discussion
of the construction and strict interpretation of
the Directional Day Filter. Following the section
on the basics of the tool we will include a considerable
number of actual price charts taken from real markets,
going through extensive descriptions of the actual
application of this indicator. Careful study of
these selected charts will begin to give you an
appreciation of the many different and varied ways
this indicator can be utilized in your trading.
But it will only be with the close observation of
many, many days of intraday charts as they unfold
during market hours using this tool that you will
gain the knowledge necessary to make full and proper
use of this unique indicator.
Trend
of the Day
As mentioned above, this tool is used to define
the trend of the market in question for the remainder
of the trading session. The seasoned chart observer
will agree that quite often the high or low of the
trading session will be established within the first
hour of the day. This trading aid attempts to determine
whether the high or the low of the day has been
established early in the session. If the low is
established then we will expect any range expansion
that will occur for the rest of the day to be on
the high side of the market. In other words, if
we are certain that the low of the day is in place,
we will then expect a series of new highs to be
established as the trading session progresses. If,
on the other hand, we can determine with a reasonable
degree of certainty that the high of the day has
been established by a given time, we should then
see any range expansion develop on the low side
of the market with a series of new lows established
for the remainder of he day.
Thus our definition of an uptrend for the rest
of the day is a day in which the low is established
for the market early in the day and one or more
new highs are made during the remainder of the session.
Conversely, our definition of a downtrend as indicated
by this trading tool is a day in which the high
of the day is established early and the rest of
the day is featured by the establishment of at least
one new low for the day.
It is quite important to understand this definition
and keep it in mind as we move through the trading
examples in later chapters.
Why is
this important?
One of the most basic theories of trading is the
concept of trading in the direction of the dominant
trend in the market. The old adage "the trend
is your friend" should never be forgotten by
the serious trader. It is a concept vital to your
financial survival.
Trading with the trend is important regardless
of the time frame of your trading environment. It
is just as important for trading on a daily, weekly,
monthly, or in our case, an intraday chart.
Working with many traders over the years I have
noticed one thing common to all beginning traders
- the attitude that they are smarter than the market
and "just know" that the top of the market
has been made for the day and that "it’s just
got to go lower from here". There are a variety
of trading tools and attitudes that can create this
false impression for many traders.
The usefulness of the directional day filter is
to keep the perspective of the day trader on the
bigger picture. Quite frequently, especially when
working with extremely short time frames, the active
day trader will lose perspective of the entire day
when concentrating on the extremely narrow focus
of perhaps only a few minutes.
The concept is quite basic. If you have defined
an uptrending day, you will take only the buy side
of the market, thereby trading with the trend of
the day, which is higher. If you have determined
that the dominant trend is lower, you will trade
only the short side of the market, again in the
direction of the dominant trend. If you have determined
that there is no dominant trend for the day, you
can be confident in taking trades on both sides
of the market, understanding that there probably
will be no extended moves in any one direction for
the remainder of the trading session.
This concept of trading in the direction of the
dominant trend is not only useful for entering trades.
It also finds important uses when the time comes
to exit your trade.
The oscillator indicators which we will use later
in the book to define entry points for trades will
give both buy and sell signals throughout the course
of any trading day. During an uptrending day, the
sell signals issued by our oscillator indicators
will not be used to establish new short positions,
since these trades would be taken opposite to the
major trend of the day. Instead the sell signals
can be used as a criteria to be considered for the
exiting of a long trade. Oppositely, buy signals
given on a downtrending day can be used as exit
points for existing short positions.
In
a previous chapter dealing with day trading methods
and philosophies mention was made of a long term
day trading strategy. This type of trade attempts
to stay in a trend for most of the day. Using the
Directional Day Filter to get you in a trade in
the right direction for this long term transaction
is an option certainly worth considering.
How it
works
The Directional Day Filter is actually more of
a chart reading tool than an indicator itself. Although
it can be programmed to automatically plot on your
screen and give actual trading alerts, it is not
necessary to do so. A simple interpretation of a
chart pattern early in the day will give the trader
all the information necessary to determine the major
trend of the day.
After five minutes of the market day has passed,
record the highest price which the market has reached
at this point in time. Also record the lowest price
of the day at the same time. Be sure to use only
the day session data in your calculations. No overnight
data is to be included here. From the data you have
recorded, an average price for the first five minutes
of the day can be calculated by adding the two recorded
prices and dividing by two. The resulting price
is the critical price level which you will use for
the rest of the trading session to determine the
trend of the day.
The next critical chart examination for the use
of the Directional Day Filter comes after the market
has traded for one hour. It at this point that you
will determine, with a high degree of likelihood,
the dominant trend for the remainder of the trading
session.
The vertical bar placed on the chart above identifies
the first 60 minutes of trading for the day in question.
It is at this time, in most instances, that you
will be making the initial observation involving
the Directional Day Filter. At this point it is
critical to determine the amount of market activity
which has occurred both above and below the line
which marks the average of the first five minutes
of trade.
If there is substantially greater activity above
the average line than below the line at this time
of the session the odds are significantly in favor
of the trend for the rest of the day to be higher.
Conversely, if there is more market activity below
the line than above there is a greater tendency
for the market to trade lower for the remainder
of the trading session in question.
Additionally, it is important to note the close
of the bar that is present at the time the above
determination is made. In other words, if the determination
of the amount of activity is to be made 60 minutes
into the trading day then pay close attention to
the close of the bar which marks this time on the
chart. If the close of this bar is significantly
above our average line there is now additional evidence
that the remainder of the day will show a higher
trend. If the close of this bar is significantly
below our average line then we have further likelihood
of new lows being made later in the session thereby
producing a downtrend for the rest of the day. Closes
of this bar which lie relatively close to our average
line would tend to give the interpretation of the
trend for the day as outlined by this trading tool
a more neutral flavor.
The measure of activity to which I refer on these
charts is defined as strictly the number of trades
which have occurred above or below our average line.
This does not refer to the number of closes, the
number of highs, the number of lows, the number
of complete bars, etc. It is strictly an observation
of the general amount of trading activity which
has occurred on either side of this critical average
line which we calculated earlier.
Although it is certainly possible to calculate
the number of trades above and below our average
line and keep a running total of these values as
the trading day progresses, it is not usually necessary
to do so. Again, recall that many of these tools
work as they do because they are used extensively
by the many people who trade these markets. Most
of these traders watch this activity and interpret
the unfolding patterns strictly by observation.
Therefore it is also wise for you to make the same
observations.
Since this tool is intended to be interpreted strictly
by observation of the amount of activity both above
and below the line at a particular time in the trading
day, there will obviously be days and times at which
there is no observable difference in these two activity
patterns. The trader will, on selected days, have
difficulty in determining if the activity above
the line is greater than that below the line, or
vice versa. When you find yourself in this situation,
there are two routes of activity that you may pursue
from this point forward.
The most frequent, and usually the most accurate
interpretation of this type of chart pattern will
be to classify the trend for the remainder of the
trading session as a sideways day, or one in which
no definite trend is expected to develop as the
trading day progresses into the close of the day.
On the days when a trendless day is expected from
the observation of the Directional Day Filter, the
trader can have equal confidence in taking trades
from both a long and a short perspective. Since
the development of a dominant trend is not anticipated,
those minor trends that do appear are not expected
to remain active for any substantial period of time
and can be projected to reverse after moving in
any particular direction for a relatively limited
objective, both in time and price. Therefore both
long and short trades should have trading potential
on these defined sideways days.
Secondly, one may wish to once again observe the
relative activity above and below the line at a
point a bit later in the day and re-assess the determination
of the major trend of the day at this point. This
may be particularly true on certain days when the
trader, from a fundamental or technical point of
view, feels a definite trend should develop sometime
during the trading session. Although delaying this
prediction is certainly acceptable, I would personally
not extend this observation point beyond 2.5 hours
into the trading session. I would restrict the determination
to this time frame mainly due to the fact that the
60 minute time frame has been shown by extensive
research to be highly reliable. When you do discover
that a particular technical indicator is quite accurate
when used in a set manner it is often not wise to
override the output of such a tool. Working with
many traders over the years, I have often heard
the comment that "Had I just followed my own
trading rules I wouldn’t be in this much trouble
with my trading account".
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