DIRECTIONAL DAY FILTER

Think about your day trading activities for a moment. The profits were exciting and rewarding. The losses were awful. More wins would be great.

But, fewer losses can truly turn your day trading into the profitable enterprise 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 today as the day it was first stated by someone long ago. But now lets 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 to 20 percent.

One of the purposes of this book is to teach you to increase significantly the proportion 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 session 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 making up the fundamental picture that affects 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 that 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. After mastering the interpretation of this simple concept, you will be able to predict with a high degree of accuracy an uptrending day, a downtrending day, or a sideways, trendless day.

The accurate interpretation of trading indicators is frequently as much 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 it 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, 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 the day.

Thus our definition of an uptrending 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 downtrending day 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 these definitions and keep them 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 beginning traders-the attitude that they "just know" that the top of the market has been made for the day and that "its 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

useful not only for entering trades. It also finds important uses when the time comes to exit your trade.

The oscillator indicators we will use 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 criteria to be considered for the exiting of a long trade. Oppositely, buy signals given on a down-trending day can be used as exit points for existing short positions.

In Chapter 1, "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 plot on your screen and give actual trading alerts automatically, 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 the market has reached at this point in time. Also record the lowest price of the day thus far. 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 you will use for the rest of the trading session to determine the trend of the day.

Figure 10.1 illustrates this simple, yet critical, calculation.

For this illustration well use data from the S&P 500 futures market from July 7, 2000. Note that this is a one-minute chart, with each bar graphing all the price activity for each minute of trading. Note that the high of the day during the first five minutes of trading was established on the first two bars of the day at 1,479.50. The low for