Trading Strategies (Short Term): Filter Rule

In this article, I will explain one of the trading strategies that is attempted by traders to benefit from the price movements of the stocks.

This trading strategy is called the “Filter Rule” and falls under the so-called serial correlation strategy.

In a filter rule, an investor gets into a buying position i.e. buys a stock if the price rises X% from a previous low of the stock and then holds the stock until the stock price reaches to below X% from a previous high. The magnitude of the change (X%) that triggers the trades varies from filter to filter depending upon the value of X selected by the trader. However, smaller changes result in more transactions per period and higher transactions costs.


The simple assumptions that are followed in this trading strategy are:
• Price changes are serially correlated and that emerges from price momentum theory, i.e., stocks which have gone up strongly in the past are more likely to keep going up than go down.

The following table summarizes results from a study on returns, before and after transactions costs, on a trading strategy based upon filter rules ranging from 0.5% to 20%. ( A 1% rule implies that a stock is bought when it rises 1% from a previous low and sold when it falls 1% from a prior high.)
(Table based upon empirical results available in various books and internet)


Results and interpretations of Table above:

􀁑 The one and only filter value that beats the returns from the buy and hold
strategy is the 0.5% value, but it does so before transactions costs.
This strategy creates 12,514 trades during the period which generate
enough transactions costs to wipe out the principal invested by the
investor.
􀁑 While this test is dated, it also illustrates a basic problem with
strategies that require frequent short term trading. Even though
these strategies may earn excess returns prior to transactions costs,
adjusting for these costs can nullify the returns completely.

So in conclusion, this strategy may work provided each time your bets are good. However, a good and justified way of making money from this strategy is through efficient money management. Try and attempt to double and triple your bets if the previous one goes wrong, and look for opportunities. Then and only then this strategy may give some fruitful results. Remember, be ready to get wiped off completely, and be prepared with big money if following this strategy.

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