APRIL 1 11 COMMENTS

Building A Better Trend

Filter
By Jeff Swanson
April 1, 2019

Automated Trading Development,

EasyLanguage, filter, Trend Following

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In this article I will create a trend filter (also

known as market mode filter or regime filter)
that is adaptable to volatility and utilizes
some of the basic principles of hysteresis to
reduce false signals (whipsaws). As you may
know, I often will use the 200-period simple
moving average (200-SMA) to determine
when a market is within a bull or bear mode
:
 on a daily chart. When price closes above our
200-SMA we are in a bull market. Likewise,
when price is below our 200-SMA we are in a
bear market. Naturally, such rules will create
some false signals. By the end of this article
you will have a market mode filter that can be
used in your system development that may
produce better results than a standard 200-
SMA filter. To build our better market trend
filter we will use the following concepts:

Hysteresis

Price proxy

Hysteresis Basics

When building trading systems many of the

decisions have a binary outcome. For
example, the market is bearish or bullish. You
take the trade or you don't. Introducing a
"gray area" is not always considered. In this
article I'm going to introduce a concept called
Hysteresis and how it can be applied to our
trading. Hysteresis was used in a previous
article on reducing whipsaws within a moving
average crossover trading system. While the
word Hysteresis was not used specifically in
that article, it was a good example.

The common analogy to help understand the

:
 concept of hysteresis is to imagine how a
thermostat works. Let's say we are living in a
cool weather climate and we are using a
thermostat to keep the temperature of a room
at 70 degrees F (critical threshold). When the
temperature falls below our critical threshold
the heaters turn on and begin blowing warm
air into the room. Taking this literally as soon
as the temperature moves to 69.9 our heater
kicks on and begins blowing warm air into the
room driving the temperature up. Once the
temperature reaches 70.0 our heaters turn off.
In a short time the room begins to cool and
our heaters must turn on again. What we
have is a system that is constantly turning off
and on to keep the temperature at 70 degrees.
This is inefficient as it produces a lot of wear
on the mechanical components and wastes
fuel. As you might have guessed, hysteresis is
a way to correct this issue. More in just a
moment.

The purpose of this article is to improve our

market mode filter. Below is the result of
buying the S&P cash index when price closes
above the 200-SMA and selling when price
closes below the 200-SMA. This is similar to
our thermostat example. Instead of turning on
the furnace to heat a room we are going to
:
 open a new position when a critical threshold
(200-SMA) is crossed.

In order to keep things simple, there is no

shorting. For all the examples in this article,
we are starting with a $100,000 account and
risking $1,000 for each trade. The number of
shares is scaled based upon a 20-day ATR
calculation. To account for slippage and
commissions $30 is deducted for each round
trip. The backtest was performed from August
1, 2020 going back 50 years.

Below is the code for opening and closing a

new position.

SMA_Line = Average( Close, 200 );

If ( Close > SMA_Line ) then Buy next bar at
market;
If ( Close < SMA_Line ) then Sell next bar at
market;

Below is the code for opening and closing a

new position.

SMA Cross Only

SMA Crossover
:
 Net Profit $49.233

Profit Factor 3.13

Total Traders 170

%Winners 23%

Avg. Trade Net

$290
Profit

Annual Rate of
1.39%
Return

Sharpe Ratio -.02

Max
Drawdown(intrada $5,215
y)

Expectancy 1.63

Expectancy Score 5.63

In the above image we can see we entered

:
 into the market six times before the trade
moves significantly in our favor. The first five
attempts were closed at a loss as price moved
from bull territory back to bear territory. That’s
five consecutive losing trades!
Trading Bands

Going back to our thermostat example, how

do we fix the problem of the furnace turning
on and tuning off so many times? How do we
reduce the number of signals? Let’s create a
zone around our ideal temperature of 70
degrees. This zone will turn on the heaters
when the temperature reaches 69 degrees
and turn off when the temperature reaches 71
degrees. Our ideal temperature is in the
middle of a band with the upper band at 71
and the lower band at 69. The lower band is
when we turn on the furnace and the upper
band is when we turn off the furnace. The
zone in the middle is our hysteresis.

In our thermostat example we are reducing

“whipsaws” or false signals, by providing
hysteresis around our ideal temperature of 70
degrees. Let’s use the concept of hysteresis to
attempt to remove some of these false
signals. But like our ideal temperature we
want an upper band and a lower band to
designate our “lines in the sand” where we
:
 take action. There are many ways to create
these bands. For simplicity let’s create the
bands from the price extremes for each bar.
That is, for our upper band we will use the
200-SMA of the daily highs and for the lower
band we will use the 200-SMA of the daily
lows. This band floats around our ideal point
which is the 200-SMA. Both the upper and
lower bands vary based upon the recent past.
In short, our system has memory and adjusts
to expanding or contracting volatility. The
EasyLanguage code for our new system look
something like this:

SMA_Line = Average( Close, 200 );

UpperBand = Average( High, 200 );
LowerBand = Average( Low, 200 );
If ( Close crosses over UpperBand ) then Buy
next bar at market;
If ( Close crosses under LowerBand ) then Sell
next bar at market;

Below is a screen shot showing the effect of

opening a new trade after the daily bar closes
above the upper band. We have reduced our
five consecutive losing trades down to two
trades.
:
 Here are the results with using our new bands
as trigger points.

Band Cross

SMA
Band Cross
Crossover

Net Profit $49.233 $53,786

Profit Factor 3.13 4.70

Total Traders 170 79

%Winners 23% 40%

Avg. Trade
$290 $681
Net Profit

Annual Rate
1.39% 1.48%
of Return

Sharpe Ratio -.02 0

Max
Drawdown(i $5,215 $4,029
:
 ntraday)

Expectancy 1.63 2.20

Expectancy
5.63 3.53
Score

Looking at the performance table above we

can see an improvement in nearly all aspects
of the system’s key performance. Most
notably, increased Net Profit, Profit Factor,
Percent Winners and Average Trade net
Profit. We also reduced the number of trades.
We really end up with about the same amount
of net profit but we accomplish this task with
fewer, more profitable trades.

It’s interesting to note that our Expectancy

Score falls even as we increase the
Expectancy value from 1.63 to 2.20. This is
due to the reduced number of trading
opportunities.

Price Proxy

A price proxy is nothing more than using the

result of a price-based indicator instead of
price directly. This is often done to smooth
price. There are many ways to smooth price. I
won’t get into them here. Such a topic is great
for another article. For now, we can smooth
:
 our daily price by using a fast period
exponential moving average (EMA). Let’s pick
a 5-day EMA (5-EMA). Each day we compute
the 5-EMA and it’s this value that must be
above or below our trigger thresholds. By
using the EMA as a proxy for our price we are
attempting to remove some of the noise of the
daily price fluctuations.

Below is what the EasyLanguage code may

look like.

SMA_Line = Average( Close, 200 );

UpperBand = Average( High, 200 );
LowerBand = Average( Low, 200 );
PriceProxy = XAverage( Close, 5 );

If ( PriceProxy crosses over UpperBand ) then

Buy next bar at market;
If ( PriceProxy crosses under LowerBand )
then Sell next bar at market;

Below is an example of a trade entry. Notice

the trade is opened when our price proxy
(yellow line) crosses over the upper band. We
have also reduced our losing trades to one.
:
 Let’s see how this affects our performance.

Price Proxy Band Cross

Band
SMA
Band Cross
Crossove
Cross Price
r
Proxy

Net
$49.233 $53,786 $58,004
Profit

Profit

Factor 3.13 4.70 5.87

Total
170 79 45
Traders

%Winner
23% 40% 51%
s

Avg.
Trade
$290 $681 $1,289
:
 $290 $681 $1,289
Net
Profit

Annual
Rate of 1.39% 1.48% 1.57%
Return

Sharpe
-.02 0 .01
Ratio

Max
Drawdo
wn $5,215 $4,029 $12,667
(intraday
)

Expectan
1.63 2.20 2.38
cy

Expectan
5.63 3.53 2.17
cy Score
Looking at the strategy performance table
above we are making more money. We are
being more efficient with our trades by
eliminating unprofitable trades. We have
increased our percent winners to around 50%.
Our average trade net profit is above $1,200.
However, our max drawdown has increased.

So, which strategy is better? It all depends on

what you want or what you are comfortable
with. Some people will wish to simply take as
:
 much money as possible. Others will wish to
reduce the number of consecutive losing
trades.

The above examples are designed to

demonstrate the effect a “better” trend filter
can have on a simple trading strategy. If we
want to use this in a trading system it would
be ideal to create a function from this code
that would pass back if we are in a bear or
bull trend. However, the programming aspect
of such a task is really beyond the scope of
this article. Nonetheless, below is a quick
example of setting two boolean variables (in
EasyLanguage) that could be used as trend
flags:

BullMarket = PriceProxy > UpperBand;

BearMarket = PriceProxy <= LowerBand;

In this article we have created a dynamic

trend filter that smooths price, adapts to
market volatility and utilizes hysteresis
principles. With just a few lines of code we
can significantly reduced the number of false
signals commonly associated with this style of
trading strategy . This type of filter can be
effective in building the trading systems for
ETFs, futures and Forex.
:
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 Jeff Swanson

About the author

Jeff has built and traded automated trading
systems for the futures markets since 2008.
He is the creator of the online courses System
Development Master Class and Alpha
Compass. Jeff is also the founder of
EasyLanguage Mastery - a website and
mission to empower the EasyLanguage
trader with the proper knowledge and tools
to become a profitable trader.

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