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

TRADING TECHNIQUES

Using Filtered Waves For Trend

Analysis

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 data
for reliable patterns as well as some suggested trading plans.

by Scott Barrie

Copyright (c) Technical Analysis Inc.

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

T echnical 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 are
appropriate to examine and then building trading schemes on those patterns. Here are the methods I employ to
discern 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, or
the difference between starting and ending values; second, the duration, or how long it takes to move from beginning
to end; and finally, the path, or which direction, up or down, from start to finish. The best process I have found for
breaking 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 all
moves less than a certain percentage, x %, and only look at moves greater than x %. I use a 1% filter to create a
makeshift actuarial table of all absolute price movements greater than 1% (Figure 1). By using filters, I solve two of
the 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%.

LAYOUT
Before I go into the results of my analysis, these are the steps I used to analyze the T-bond market. The data was
from Technical Tools daily data for the Chicago Board of Trade (CBOT) 30-year Treasury bond contract, from
January 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 to
contract expiration; for example, for the December 1979 contract, I used the first trading day in January 1979 until
the contract expired. In Excel, I floored all percentage waves to the nearest 1%, meaning that all moves from 1% to
1.99% were grouped together as a 1% wave. This process was performed for all moves greater than 1% all the way
to 7%, while all moves greater than 8% were lumped together. The same process was applied for negative waves.

Copyright (c) Technical Analysis Inc.

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

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 contract
year 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 grouping
from 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 added
to the average days without 1% opposite move (column 3), presented in trading days, and rounded to the nearest
whole day.

Average retrace percent (column 5): The average percentage of the next wave following a wave of column 1
magnitude. 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 our
7% wave, the reaction wave should take three days on average. Results are presented in trading days, not calendar
days.

Standard deviation of average days' retrace (column 7): The standard deviation of all waves of a given
magnitude 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 wave
of column 1 magnitude.

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

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

PATTERNS AND TRENDS

I have noticed that several patterns seem to pop up in pairs at potential market turning points. A potential market
turning 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 individual
pattern occurred at an actual turning point.

Copyright (c) Technical Analysis Inc.

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

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

Copyright (c) Technical Analysis Inc.

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

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 this
phrase and in the two phrases in the following paragraph are required by Microsoft Excel). In waiting for patterns to
be 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 a
significant pattern, mom_slow, and key_reversal on October 7, 1994. The duration of the move was 17 days when
the patterns fired, so my objective was 3% higher than 97-01, -3% wave apex, to be achieved in the next six trading
days. 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 four
days later and yielded a 28-tick profit.

Copyright (c) Technical Analysis Inc.

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

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

In addition, the filter method is also an excellent tool for determining the market trend. The next highest filtered wave
can 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 the
opposite direction.

FINI
Most technical trading methods filter price movement; a moving average smoothes the daily numbers, removing
short-term fluctuations, while point & figure charts only plot movements beyond a certain number of price
increments. In fact, if you switch from daily charts to weekly, you've applied a filter to the daily charts. But a price
filter more than just removes the noise from the markets; it can be used to classify market movement. With that
information 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 for
the Cumberland Group, a coalition of Chicago Mercantile Exchange members making the transition from floor
trading to long-term trading.

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

Copyright (c) Technical Analysis Inc.

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