Using Filtered Waves for Trend by Scott Barrie

TRADING TECHNIQUES

Using Filtered Waves For TrendAnalysis

Filtering is simply processing price data to remove extraneous, noisy,information. What's left after filtering can be considered to be the more

important and perhaps tradable information. Here's a method to filter price datafor reliable patterns as well as some suggested trading plans.

by Scott Barrie

Stocks & Commodities V13 (282-287): Using Filtered Waves for Trend Analysis by Scott Barrie

Copyright (c) Technical Analysis Inc.

Technical analysts use past market behavior as a guidepost for future behavior. By studying the past, an analyst

can glean patterns that can be used as the basis for trades. The challenge is determining which past behaviors areappropriate to examine and then building trading schemes on those patterns. Here are the methods I employ todiscern patterns, and the trading schemes I use in the Treasury bond futures market.

To compare present price action with the past, we must examine three facets of price behavior: first, magnitude, orthe difference between starting and ending values; second, the duration, or how long it takes to move from beginningto end; and finally, the path, or which direction, up or down, from start to finish. The best process I have found forbreaking down moves is the filtered wave method discussed by Arthur Merrill in his Filtered Waves, Basic Theory .

Filtering is the process of ignoring some data to discern a more telling picture from the remaining data: Ignore allmoves less than a certain percentage, x %, and only look at moves greater than x %. I use a 1% filter to create amakeshift actuarial table of all absolute price movements greater than 1% (Figure 1). By using filters, I solve two ofthe three problems - magnitude and path. Then I use observed duration of the historical moves as my timing method,looking for moves that are overdue according to past average duration.

FIGURE 1:This table classifies the price movement of the market with price swings greater than 1%.

LAYOUTBefore I go into the results of my analysis, these are the steps I used to analyze the T-bond market. The data wasfrom Technical Tools daily data for the Chicago Board of Trade (CBOT) 30-year Treasury bond contract, fromJanuary 1, 1979, to December 17, 1993. I exported the data and used a Microsoft Excel spreadsheet to analyze it.(See sidebar, "Filtering in Excel.") I only used the December contract from the beginning of the contract year tocontract expiration; for example, for the December 1979 contract, I used the first trading day in January 1979 untilthe contract expired. In Excel, I floored all percentage waves to the nearest 1%, meaning that all moves from 1% to1.99% were grouped together as a 1% wave. This process was performed for all moves greater than 1% all the wayto 7%, while all moves greater than 8% were lumped together. The same process was applied for negative waves.



The results of the data I analyzed appear in Figure 1. The information that follows is illustrated there:

Percent move without 1% opposite move (column 1): The percentage change from inception of the wave(start) to apex (maximum percentage move in given direction) until an opposite move of 1% or more is registered.This column is sorted by the flooring method described above.

Occurrences (column 2): The number of 1% waves that make up this group. The last move of each contractyear is removed because no further data can be gleaned from it.

Average days without 1% opposite move (column 3): The average duration of the wave in the groupingfrom inception to apex, rounded to the nearest whole day and given in trading days, not calendar days.

Look for correction after (column 4): The standard deviation of length of each occurrence in each row addedto the average days without 1% opposite move (column 3), presented in trading days, and rounded to the nearestwhole day.

Average retrace percent (column 5): The average percentage of the next wave following a wave of column 1magnitude. For example, a 7% move usually has a reaction of -2.54% from the apex of the 7% move.

Average days' retrace (column 6): The average days to complete the wave described in column 5. Using our7% wave, the reaction wave should take three days on average. Results are presented in trading days, not calendardays.

Standard deviation of average days' retrace (column 7): The standard deviation of all waves of a givenmagnitude described in column 5, rounded to the nearest day, and presented in trading days.

Maximum percent retrace (column 8): The largest (absolute value based) retracement wave, given a waveof column 1 magnitude.

Minimum percent retrace (column 9): The smallest (absolute value based) retracement wave given a wave ofcolumn 1 magnitude.

Developing a system from Figure 1 is our next step. Check the magnitude of the wave we are in at present and thenlook for waves that are due for a reaction. Then I classify a reaction as being due if the duration of the present waveis equal to or greater than the average wave duration plus the standard deviation of the duration minus one tradingday (column 4, "Look for correction after" in Figure 1).

PATTERNS AND TRENDSI have noticed that several patterns seem to pop up in pairs at potential market turning points. A potential marketturning point is one in which the duration of the given wave is equal to or exceeds column 4 of Figure 1 minus 1.Figure 2 describes some of the patterns that I use and Figure 3 lists the percentage of times that each individualpattern occurred at an actual turning point.



FIGURE 2: PATTERNS. Here are the definitions of the technical patterns for entry signals.



FIGURE 3: This table shows the percentage of times that the patterns appeared in each year.

For my trades, I require two or more patterns to be present, unless the previous day is a doji † or juke (Figure 2).If this is the case, then only a gap or a "key_reversal" is necessary (Editor's note: The underlined portions in thisphrase and in the two phrases in the following paragraph are required by Microsoft Excel). In waiting for patterns tobe fired, you are waiting to see some sign of a market turn, which by now historically is overdue.

An example of a trade I made recently (Figure 4) is a -3% wave that started on September 15, 1994, which gave asignificant pattern, mom_slow, and key_reversal on October 7, 1994. The duration of the move was 17 days whenthe patterns fired, so my objective was 3% higher than 97-01, -3% wave apex, to be achieved in the next six tradingdays. I like to downsize my objectives by taking the average of the average move and the minimum retracement(Figure 1, columns 5 and 8, respectively), which gave me an upside objective of 99-03, which was achieved fourdays later and yielded a 28-tick profit.



FIGURE 4: DECEMBER TREASURY BONDS. Here's a recent trade based on the -3% decline into anoversold condition by the market.

In addition, the filter method is also an excellent tool for determining the market trend. The next highest filtered wavecan be used to determine the trend. I use a 3% filter, and whatever the 3% wave designation is determines the trend.Another method is to look at reactions and see if they consistently make their objectives (average percent retrace,Figure 1, column 5); when there are two or more failures to meet the average, trends should be designated for theopposite direction.

FINIMost technical trading methods filter price movement; a moving average smoothes the daily numbers, removingshort-term fluctuations, while point & figure charts only plot movements beyond a certain number of priceincrements. In fact, if you switch from daily charts to weekly, you've applied a filter to the daily charts. But a pricefilter more than just removes the noise from the markets; it can be used to classify market movement. With thatinformation in mind, you can design trading plans based on the historical analysis.

Scott W. Barrie, 312 258-6924, is a member of the MidAmerican Commodity Exchange and head of research forthe Cumberland Group, a coalition of Chicago Mercantile Exchange members making the transition from floortrading to long-term trading.

REFERENCEMerrill, Arthur A. [1977]. Filtered Waves, Basic Theory, Technical Trends.



Using Filtered Waves for Trend by Scott Barrie

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