We’ve all heard the market is random and the odds of winning are only 50/50. However, even in its randomness the market will still experience winning and losing streaks. Just making the small changes we’ve already discussed, gives you a simple way to increase your trading edge and the likelihood of having longer winning streaks with fewer losing trades expected for your natural trading style.
Our next section will describe three additional ways to increase your odds of profitability by keeping you out of the market during times of increased risk. Those who are successful in the markets know how to manage their risk. They use a “when in doubt, sit it out” philosophy to preserve their gains and limit their losses.
The market filters we show in this section of the lesson are general enough to work with many systems and are a great way for you to start analyzing the markets in a more professional way. Our goal in presenting these three additional market filters is to teach you the concept of using filters to keep you out of bad trades, not to confuse you with conflicting signals. If you have to choose, start with something you can implement easily first. Then add in additional market filters as your skills improve. Remember, “paralysis by analysis” is a real danger and you can only be successful in the markets if you are actually in the markets and can exit your positions when necessary.
That said, understanding some overarching market dynamics can keep you from getting into trades at the very worst time. Below are three general market filters which you may choose to add to your current system of filters to increase your probabilities of winning.
The three market filters you should be aware of and may want to consider using:
- A Moving Average on the S&P 500
- The level of the Volatility Index (VIX)
- The trend of a relevant benchmark index.
MARKET FILTERS – Moving Average on the S&P 500
Applying a moving average to the S&P’s ETF (SPY) is a way to determine if you are bullish or bearish the market. If the price of the SPY is above the moving average you’ve selected, you are bullish and should only do things that make money if things go up. If the price of the SPY is below the moving average, you’re bearish and should only choose strategies and positions that make money when markets fall.
The simplest BULLISH implementation of this filter is:
- If the price of SPY is above an upward trending moving average, then enter new bullish trades.
- If the price of SPY is below an upward trending moving average, then don’t enter any new bullish trades.
The simplest BEARISH implementation of this filter is:
- If the price of SPY is below a downward trending moving average, then enter new bearish trades.
- If the price of SPY is above a downward trending moving average, then don’t enter any new bearish trades until previous direction has been confirmed.
The length of the moving average used determines the sensitivity of the signal. Longer moving averages slow things down, keeping you in trades longer but sacrificing some profits at both the top and the bottom of a range. Shorter time frames get you in and out closer to market bottoms and tops but could cause portfolio churn as you get whipsawed into and out of positions unnecessarily. Consider the following examples: