Hello Forex traders,
Last week’s article introduced the TOFTEM model, which is a method for traders to structure their trading plan. That model recommends using 5 clear steps when tackling the market.
This model is also part of a process when Forex traders build their strategies. Read more about this here:
Traders want to make sure that they know what they are looking for when analyzing the market and that they have a clear definition of:
5) Entry Method
Today’s focus is point 3: FILTERS.
PROCESS OF A SETUP OR TRADE
The previous articles discussed what type of environment (trend, reversal, range) traders are looking for to trade and what kind of opportunity (chart patterns, S&R, etc) do they consider interesting with their environment.
When the market meets the conditions a trader is looking for, then there is a potential trade setup. A potential trade setup still needs to be checked for filters. If there are not filters blocking the potential of a trade setup, then we have a confirmed trade setup but not yet a trade.
Only when a trigger and a clear entry are present, will the confirmed trade setup turn into an actual trade. Here is an overview of the process:
1) Trend – currency pair matches chosen environment and definition –
initial interest – continue to step 2 / if not, go to new pair
2) Opportunity – currency pair has chosen opportunity –
potential trade setup – continue to step 3 / if not, new pair
3) Filters – currency pair has no filters –
confirmed trade setup – continue to step 4 / if not, new pair
4) Trigger – currency pair has a trigger –
potential trade – continue to step 4 / if not, new pair
5) Entry method – trader decided which way to enter –
actual trade – entered the market / if not, new pair
WHAT ARE FILTERS?
Filters are elements or aspects (both on and off of the chart) which are always reviewed by the trader when a potential trade setup occurs.
Which aspects will depend from trader to trader, although concrete examples will be provided in a later part of the article. Generally speaking, in the WET trading room we use news events (off chart), bank holidays (off chart), technical analysis (on chart), and reward to risk ratios (money management) elements as filters.
If the filters are hindering or blocking the trade from materializing, then the potential trade setup is negated and the trader can move on to looking at new pairs and charts.
If the filters are not hindering or blocking the trade from materializing, then the potential trade setup is confirmed and the trader can move on the next step in the TOFTEM model, which is the trigger.
WHY USE FILTERS
First of all, a potential trade setup usually does not equal an actual entry / trade because the trader would be overtrading. Most strategies create lots of setups, but not all setups are created equal. That is when filters step in.
Filters must have a positive impact by either reducing the number of losing trades, or by reducing risk in periods of high volatility and insecurity (such as a NFP news event).
Filters are therefore useful to decrease the number of trades which have less chance of success than other setups. This process is basically filtering out setups (hence the word filters) and distinguishing the profitable ones from the less profitable ones.
At the end of the day, Filters should on average have a positive net impact on the bottom line, also known as the monthly profit or loss, otherwise the filter becomes obsolete. Of course, it can and will always happen that some profitable trades are filtered out, but on average the filter impact should be positive for the expected profit.
TYPES OF FILTERS
Traders can use discretionary or non-discretionary filters.
Discretionary filters: the trader reviews a chart with their usual tools and indicators to judge whether the setup meets the conditions of the trading plan. Which tools and indicators are used could vary from case to case, or the interpretation of the tools and indicators can differ.
Non-discretionary filters: contrary to the above, in this case traders use fixed levels and interpretations when judging filters.
EXAMPLES OF FILTERS
Remember, traders are trying to filter on average trades with higher chance of turning into a loss. That is traders want to analyze the market and judge whether there is an aspect that could hinder a setup from materializing. Here are examples:
1) News events
2) Bank holidays
3) Support and resistance
4) Fibonacci retracements
5) Oscillator values
6) Tops and bottoms
8) Trend lines
9) Trend channels
10) Price action
11) Candle stick patterns
12) High and lows of candles
13) Currency correlations
14) Time of the day, week, month
15) Currency pair characteristics
A trader does not usually use all of the above mentioned examples, but the list was compiled to provide a good source of inspiration for traders who are developing this part of their trading plan.
WHEN ARE TRADES BLOCKED?
Beyond the examples provided in the above paragraph, the best thing a trader can do is to think conceptually why a potential setup could not materialize. This answer will vary from setup to setup. Basically the trader needs to understand the weakness of their strategy.
Just as a trader can map out their own strengths and weaknesses, the trader can complete the same for their strategy or strategies. By understanding in which scenario their strategy is more vulnerable, the trader can attempt to create solutions (filters) which help improve the results of the strategy.
Which filters are actually useful depends on the parameters of the strategy:
A with the trend trader could realize that their strategy is especially vulnerable when there is divergence present on the 4 hour chart and add this to their list of filters.
A range trader could realize that their strategy is especially vulnerable when there is high impact news event which could let price spike up and down and thereby break the range.
A reversal trader could realize that their strategy is especially vulnerable when price is near a major Fibonacci level which could act as a turning point for the trend.
Last but not least, before implementing a filter, always check and make sure what the impact is of your chosen filter.
Do you use filters and why? Which filters do you find the most profitable? Let us know down below!
Thank you all for reading and sharing this article and wish you Good Trading!
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