iiMil.iliim Ch.nl (DSP lllll SSP [ Inilrac 0.,v

DSP UO 1 8 -1 min 07/0772000 0=1494.50 -21.70 Hlgh-147S.S0

Average - 1478JO0

1478.00 1477.S01 1477.00 U7B.50

Figure 10.1 The first step in the calculation of the Directional Day Filter is the determination of the average range of the first five minutes oftradiag.

Chart created with TradeStation® 2000i by Omega Research, Inc.

our period of interest was placed by the fourth and fifth bars at 1,476.50. Simply averaging the two prices (1,479.50 + 1,476.50 = 2,956; 2,956 -j- 2 = 1,478 ) gives us our average price of the first five minutes of trade of 1,478. This average price is marked on the chart by the heavy black line beginning on the 8:35 bar and extending to the right of the chart.

Although I am using a standard five-minute calculation time throughout the book, readers are cautioned that other time frames could be more appropriate for other individual stock issues or contracts. Traders should undertake careful study of each issue or contract to be analyzed with this indicator using multiple time frames for calculating the average. Such research may reveal a more useful setting for the filter when adapting it to your individual trading style.

The next critical chart examination for the use of the Directional Day Filter comes after the market has traded for one hour. It is 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 Figure 10.2 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

fi I mhSUUw Chail (DSP UOJSiP SOU Indea Oaf Only LAST1

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»„>,/J

L-l 4SS.00 111

high -1479.50 ,

Average 1473.00-

I nw -1476.50

1402.00 1480.00 1478.00

Figure 10.2 The second portion of the Directional Day Filter is a vertical bar drawn after 60 minutes oftrading that extends from the intraday high to the intraday low at this point in time.

Chart created with TradeStation® 2000i by Omega Research,Inc.

Directional Day Filter. At this point it is critical to determine the amount of market activity that has occurred both above and below the line marking the average of the first five minutes of trading.

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 that 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 that 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 that 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, and so forth. It is strictly an observation of the general amount of trading activity that has occurred on either side of this critical average line that 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 observe the relative activity above and

below the line once again at a point a bit later in the day and reassess 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 two and a half hours into the trading session. I would restrict the determination to this time frame mainly due to the fact that the 60- to 90-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, "Had I just followed my own trading rules I wouldnt be in this much trouble with my trading account."

In Chapter 2, which discusses various aspects of trader psychology, I mentioned not following a system as a significant factor in the failure of a number of traders. Here is an example of how this problem can develop. If you have determined that 60 minutes is the correct time frame for your stock, stick with this parameter setting until further research dictates a change. Dont make such a basic change in your trading routine just because 50 minutes or 70 minutes would have been better for that last trade.

As we will discuss further in this chapter, individual traders may wish to use times other than the first hour of trading to assess this market factor. Your own individual trading style will certainly dictate the manner in which you use not only the Directional Day Filter but also many of the other tools that we discuss in this book. The important point is that you apply the tools in a consistent manner that is compatible with your own personal style and comfort level.

Also, since various markets have their own personalities with respect to the individual trading tools discussed in this book, there may be, for each individual market being observed, selected prime times that are used most effectively for the determination of the trend of the day.

Observation of several stock issues that display varying levels of early-morning activity have revealed that the so-called prime time at which to determine the trend for the rest of the day using the Directional Day Filter can vary from as soon as 30 minutes into the trading day to well over 90 minutes.

See the data tables in the Data Appendix for more details on the application of various determination times on several stock issues.

In Figure 10.2 we have determined that almost all of the activity 60 minutes into the trading day is above our average line, suggesting the trend for the remainder of the day on this chart should have an upward bias. An additional indication of an uptrend is given by the close of the 60-mirmte bar being found considerably above the average line. Figure 10.3 below contains the complete chart for the day in question.

In the chart you will observe five black arrows that identify the new highs for the day as the trading day progresses. Note that five new highs were made for the day while the low for the day remained unchanged. Thus the day meets our definition of an uptrending day.

Also note on this chart the many small downtrends that develop during the day. When exhausted, these provide excellent opportunities to enter the market in the direction of the dominant trend (higher). Later in this book we will detail methods by which traders are able to not only identify these exhausted downtrends but also pick highly accurate points for entry into the market for the next move higher. The chart in Figure 10.4 will be used later in these explanations. Briefly, trades are generated only on the long side, which is in the direction of the major trend of the day. Although this is by no

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DSP UO LAST-1 min 07107(2000 C=.1404.5D -21.70 -1.4 0=1507.00 H=1507.50 L-H69O0 V=0

New Intraday High:

High;-14790

lfft Average 1478,00-Low = 1476.50

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Figure 10.3 Arrows detail five new intraday highs followiag the prediction of

an uptrending day by the Directional Day Filter.

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Figure 10.4 Only loag trades are taken on days when the Directional Day

Filter is forecastiag an uptrend for the session.

Chart created with TradeStation® 2000i by Omega Research, Inc.

means a perfect day to trade this or any other system, the methods used here can be successful in both taking a few small profits from the market and, more importantly, keeping us out of trouble by not trading against the trend.

Now lets examine a day displaying the opposite trend.

Figure 10.5 displays the one-minute chart of the S&P 500 futures from July 5, 2000, for the first 60 minutes of trading for that day.

First of all, note that the horizontal black line represents our average price of 1,480 and that the vertical bar marks the 60-minute point of the day.

Clearly, the majority of the trading activity in this case lies below the average line on the chart. Additionally, the close of the 60-minute bar at 1,476.50 is significantly below the average line and is relatively near the low of the day, also suggesting the tendency of the market to make additional new lows for the remainder of the session. If the established high for the day so far is not broached by trading activity then the chart will have met our definition of a downtrend for the remainder of the day.

Figure 10.6 represents the remainder of the trading activity for the same day. Note that, as expected from the interpretation of the Directional Day Filter, a persistent downtrend developed. There