A consistent and decisive method for entering the market can be achieved by defining precise trade entry rules. Many traders may find themselves naturally too conservative or aggressive when it comes to entering a trade.
Those who are too conservative may end up sitting on the sidelines while waiting for multiple levels of confirmation, a practice that commonly leads to missing trades altogether. Conversely, aggressive traders may jump at any chance to get in the market, sometimes with no valid reason other than the desire to trade. This, of course, frequently leads to losing trades.
- A trade filter allows investors to screen and select investments that meet certain criteria.
- A trade trigger is any event that meets the criteria to initiate an automated securities transaction that does not require additional input.
- Used together, filters and triggers can result in smarter, more objective trading strategies.
Trade filters identify the setup conditions that precede a trade entry and therefore must occur before the trade trigger. Trade filters can be thought of as the "safety" for the trade trigger. Once all of the conditions for the trade filters have been met, the safety is off and the trade trigger becomes active. Trade filters may include a variety of factors, ranging from time of day to location of price. For example, the trade filters for the chart in Figure 1 include:
- Time is between 9:30 a.m. and 1:00 p.m. EST
- A price bar has closed above the 20-period and 50-period moving averages
- The 20-period (blue) moving average is above the 50-period (purple) moving average
All of these trade filter conditions become true on the 9:30 bar, providing the setup for the trade trigger to be activated. Trade filters define the ideal market conditions for the trade trigger. These filters are often established through observation and backtesting. For example, a trader may have developed a trading system that performs well in the mornings but has unsatisfactory performance in the afternoons. The trader could then use a time filter to limit trade entries to a specific period of time; in this case, between 9:30 a.m. and 1:00 p.m. EST.
An important consideration in choosing trade filters is not to limit the "degrees of freedom" in a trading plan. In other words, too many filters may create a statistically improbable trading setup that would rarely, if ever, be true. This greatly limits the ability of a trading plan to be robust, consistent, and profitable. This is the situation in which the overly conservative trader finds himself: essentially filtering out most trading opportunities.
One reason why traders might over-filter a trading plan is because they attempt to eliminate all losing trades after performing historical backtesting. Backtesting refers to testing a trading plan or idea on historical data to determine if the idea could be profitable in real-life trading. While backtesting is a valuable tool for developing profitable systems, it can be misused, especially in the case of determining ways to avoid every (or most) losing trades.
This is a form of curve fitting, which manipulates the trading conditions to perform the best on historical data, while creating an unrealistic system that performs poorly in real life. When defining trade filters, traders should strive to create filters that are beneficial to the system as a whole—and not to a specific trade or two.
Once trading filter conditions have been met, traders watch for the trading trigger to occur to initiate a trade entry. Figure 2 shows this basic progression.
Trade triggers can be thought of as the line in the sand that defines exactly when a trade will be entered. Unlike trade filters that can include a variety of factors, trade triggers tell a trader exactly when to act. Trade triggers should be absolutely objective and clearly defined in the trading plan. There should be no room for ambiguity.
For instance, "go long when the moving averages cross" could be further defined with "after all trade filters have been met, enter a long position once the price is one tick above the previous bar's high." This provides the line in the sand that we need to pinpoint a precise trade entry. All of the trade filters would need to already be true in order for the trade trigger to go into effect.
In Figure 1, we see the line in the sand is drawn once all of the trade filters have been fulfilled: the time is between 9:30 a.m. and 1:00 p.m. EST; a bar has closed above the 20- and 50-period moving averages; and the 20-period moving average is above the 50-period moving average. The trigger, then, is activated once the trade filters become true. On the 9:30 bar, all of the filters became true. The trigger occurs when the price reaches one tick above the 9:30 bar's high. Price does reach this trigger, so a long trade would be initiated at the specified price.
The exact order type would depend on the trader. A system trader, for example, may place a stop order to buy to pinpoint the exact price in the trade entry. A discretionary trader, on the other hand, may place a market order to get in the trade at the best available price.
Trade triggers can be based on a variety of conditions, from indicator values to the crossing of a price threshold, such as a support or resistance level. Many traders use technical analysis tools, such as indicators, to define high probability setups in the market.
Indicators can provide an objective trade entry since precise thresholds can be easily established. Examples include occurrences such as "enter a long position when a 5,3 stochastic reaches a level of 30;" or "enter a short position when average true range reaches a level of 0.5." Filters would provide the setup for these trades; the indicator levels would provide the trigger.
An important aspect of trade triggers is that they need to be simple in order to be actionable. Too many trade triggers, or overly complicated triggers, can become burdensome and make the system difficult to implement. This can also lead to frequent trading errors as traders become confused about their own system.
Trade triggers are like a company's mission statement: they should be clear enough that they can be easily recited from memory. Triggers should be objective and readily recognizable so that there can be no question about whether or not the trigger has been met.
The Bottom Line
Trade filters allow traders to define conditions that are favorable for entering market positions. These trade filters provide the setup. Trade triggers are the line in the sand—the threshold that, once met, "triggers" the trading opportunity. Understanding how to use both trade filters and trade triggers can help traders find and define profitable trading setups.