Filter Rule: What It Is and How It’s Used

What Is a Filter Rule?

A filter rule is a trading strategy that sets parameters for when to buy and sell investments. The filter rule is commonly based on the belief that rising prices tend to continue to rise, and falling prices will continue to fall.

When using a filter rule, investors commonly mark a percentage change from prior prices. The designated percentage change may trigger a buy or sell depending on the movement of the price up or down. It is a subjective strategy, as the percentage level selected is based on the trader's analysis.

Understanding Filter Rules

Technical analysts use their discretion when setting parameters for filter rule trading. Generally, filter rules are based on historical trends and security price patterns identified from the price chart of an asset.

A technical trader may notice that when the price rises 5% above a chosen level, it tends to move another 10% in that same direction. Therefore, the trader may use a filter rule to look for stocks that move 5% off a prior closing price, low, or high.

The percentage is commonly based on short-term trends with securities moving between 1% and 10%. The levels could be smaller, such as 0.2% or 0.5% if based on intraday price movements. When using a filter rule, the trader must decide to trade in both directions, up and down, or only in one direction.

Technical Analysis and Parameters

Implementing filter rules requires software that provides technical analysis or charts that can be set for price alerts or to execute trades automatically based on an investor’s preference. Some traders elect automated trading, which allows them to take advantage of trading opportunities more rapidly.

Depending on the parameters, a filter rule can result in a large or small number of trades. Small parameters, such as 1%, will trigger far more transactions than 15% or 20%. Frequent traders must pay attention to commissions and position size. Commissions should be low enough and position size large enough to cover the costs of frequent trading on small price moves.

Trading Example

Assume a day trader is interested in applying a 0.6% filter rule on Apple (AAPL).

If the price moves 0.6% off a recent swing high or low, the trader enters. They will exit their position if the price moves 0.6% in the opposite direction from a swing high or low. The investor applies this strategy between 9:30 AM and noon EST only, and any open position is exited at noon.

The chart shows how this could have played out on a day when the stock moved over 3% during the allowed period.

The first trade resulted in a 2.29% gain. The second trade results in a 0.14% profit. The third trade results in a 0.03% profit. This assumes no slippage on orders, and commissions must also be factored in.

The strategy discussed is for demonstration purposes only and is not a recommendation or advice.

The Bottom Line

A filter rule is a trading strategy based on price movements, typically dependent on a percentage change. Technical analysis or charts help investors determine the best filter rules to apply when trading stocks.