Filter Rule and Example

What Is a Filter Rule?

A filter rule is a trading strategy in which a technical analyst sets rules for when to buy and sell investments, based on percentage changes from prior prices. The filter rule is generally based on price momentum, or the belief that rising prices tend to continue to rise and falling prices tend to continue to fall. A certain percentage rise triggers a buy, while a certain percentage fall triggers a sell.

Although, a trader could decide to do the opposite as well. It is a subjective strategy, as the percentage level selected is based on the analyst's interpretation of a stock's price history.

Understanding Filter Rules

Technical analysts use their discretion when setting parameters for filter rule trading. Generally, filter rules will be based on historical trends and security price patterns identified from the price chart of an asset. For example, a technical trader may notice that once the price rises 5% from a particular level, it tends to move another 10% in that same direction. Therefore, the trader could take advantage of this by using a filter rule and watching for stocks (or any asset for which the rule is beneficial) that move 5% off a prior closing price, low, or high. The trader or analyst also determines which price they base the move off, such the high, low, or close of a price bar, or some other technically important price level.

Typically the percentage will be based on shorter-term trends which often result in price filter triggers for securities moving between 1% and 10%. The levels could be smaller, such as 0.2% or 0.5% if based on intraday price movements.

As an example, under a 1% buy/sell filter rule, a trader buys a stock when its price rises 1% above a previous close (or low or high) and sells it when its price falls 1% below a previous close (or low or high).

The trader then also needs to decide if they are going to trade in both directions, up and down, or only in one direction. For example, if the trend is up the trader may decide to buy when the price moves up 1%, and sell when the price drops 1%, but they won't short sell when it drops 1%.

Another trader may decide to buy on 1% increases and sell and short on a 1% drop. Then on a 1% rise, they cover the short and go long again. In this case, they always have a position.

Filter Rule Implementations

Implementing filter rules requires software which provides for this feature. Generally, technical analysis trading software or charts can be set to provide alerts or execute trades automatically based on an investor’s preference.

Some traders may elect for automated trading which allows them to take advantage of trading opportunities more rapidly. When a signal is triggered the software automatically takes the trade. In other situations, traders may wish to be alerted of price changes in order to make their own investing decisions.

Depending on the parameters set, a filter rule can result a large number of trades or a small number of trades each day, week, month, or year. Small parameters, such as 1% will trigger far more trades than a filter of 15% or 20%.

When doing a large number of trades, commissions and position size are a factor. Commissions should be low enough, and position size large enough, to cover the costs of frequent trading on small price moves.

Example of a Filter Rule for Day Trading Stocks

Assume a day trader is interested in applying a 0.6% filter rule on Twitter Inc. (TWTR).

If the price moves 0.6% off a recent swing high or low, the trader will enter in that direction. They will exit their original position and reserve positions if the price moves 0.6% in the opposite direction (off a swing high or low). As a further filter, they will only apply the strategy between 9:30 AM and noon EST. 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 time period.

Image by Sabrina Jiang © Investopedia 2021

The first trade results 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. Commissions must also be factored.

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