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My 3 Bar Filter and Precise Entry Technique
by Lee Gettess

Trading in the Trenches The Buy Filter is a simple indicator that most commercial software will calculate for you. It is a three period moving average of the bars average price displaced forward one bar. Got it? For each price bar you add the High + Low + Close, then divide by 3 {(H+L+C/3}. Do this for three bars, then add those figures together and divide by 3. This figure will be used for the next bar. For instance, if today is Thursday, you would calculate the average prices for Monday, Tuesday, and Wednesday, add them together and divide by 3. On Thursday, we will be looking to see if we close below this number. If we get three consecutive closes below this moving average of average prices, we will NOT take the long trade unless it takes out the "2" point of the 1-2-3 pattern. This may be an indication that the market has gone too far, and the actual trend maybe be reversing to the other side.

Just to clarify, on Friday we would use the average prices of Tuesday, Wednesday, and Thursday. Each day (or bar) the average we are comparing that bar's close to will change. We are looking for three consecutive closes below this moving average to signal that we should cancel our buys over the highs of the bars as they are descending. The only way we could buy after this has occurred is if the market rallies enough to take out the highest high (point 2) that the intraday bars have made. This will get us in at a worse price than our system would have if it occurs, but it is generally an indication that the market may move strongly, and you do want to be on board.

There is, as you might have guessed, a Sell Filter. In the case of a sell signal that we haven’t taken yet, we wait for the market to make an isolated low, then retrace. As it retraces, we begin placing our sell stops just below the lows of the bars as they go up. However, if we get three consecutive closes above the three period moving average of the average displaced forward one bar, we cancel our sell stops. We will only sell if the market takes out the "2" point. Notice how we are basing the filters on movements of "three" again?

This particular situation does sometimes force you to have a poorer trade location than you would had you entered at the system signal. The trade-off, however, is that you sometimes totally bypass a trade that would have had you entering at the extreme of the move, then taking a very large loss. Also, if we are able to get in when an intraday bar gets taken out, the slippage tends not to be as great as it sometimes is the first time you trade through a price.

It may be confusing to talk about daily bars and intraday bars and sometimes interchange them. It is important that you understand the basic concepts of three bars in one direction, three bars above or below the moving average, etc., are applicable to any and all time frames. If you are trading some systems that are based on weekly or monthly data, you may be able to use the daily bars to filter them in a similar fashion to this discussion of using intraday to filter daily.

Perhaps the most important concept of all is to make use of the intraday price patterns to control your risk. Regardless of how you enter the market, if you use the 1 point of 1-2-3 patterns to indicate to you that your position is in trouble you should come out far, far ahead of just trading blindly. Of course, these patterns are not infallible. Sometimes you will get stopped out of a trade, only to have it come back and make money. Since you are limiting your losses tremendously, you may want to attempt to re-enter a trade you have been stopped out of if the entry signal gets hit a second time. For the most part, however, if an intraday pattern gets broken against your position, the odds of your having a good profit by remaining in the trade are quite low.

If you can understand how to watch the market from these 1-2-3 patterns on any time frame, you can develop a basic understanding of what the market is doing. In addition to the specifics we have discussed, there are also things of a more subjective nature that you can use to your benefit. For instance, if you have gotten a sell signal and the market begins to back off, you are waiting to see if it closes above your moving average three consecutive times to filter you out of taking the trade. Well, how about if the market makes a new swing high, even if it doesn't close beyond the moving average three times? Certainly a market making higher swings highs doesn't act like a market that wants to go lower! That may be an excellent reason not to take the trade at all.

You can additionally control the risk in your trades by being aware of the 1-2-3 patterns setting up against your position after you have entered. You should not be concerned unless the "2" point of the potential 1-2-3 has exceeded the "3" point of the pattern you entered on, but if it has, move your stop closer. For example, if you have bought after a 1-2-3, but then the market moves lower than the "3" point, it is setting up a potential 1-2-3 against you. Once the market has reacted back up a little, move your stop up just under the potential point "2", or the swing low that the market has just made. You would look for the opposite to occur in case of a sell.

By monitoring 1-2-3's against your position, you can begin to see when the market is obviously not going your way. By requiring that the new 1-2-3 take out the 3 point of your entry pattern, you are ensuring that you are not getting trapped by every little wiggle the market makes.

I hope those of you that have access to intraday price action will begin to make use of some intraday pattern recognition to fine tune your trading. Even if you are only picking up a tick or two per trade from all of your efforts, the dollar improvements can really add up. For instance, let's say you are trading five markets and averaging about 100 trades per market per year. If you can just improve your performance by $10 per trade, you will have made an additional $25,000 per year, if the trade is in five lots. That's more than a lot of people gross!

You will not be able to improve each and every trade. In fact, sometimes it will work against you. By and large, your overall improvement will probably be far greater than $10 per trade. Remember, even large corporations look to find savings in their mail or phone costs. Small savings add up to big dollars.

 
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