Effect of Filtering on the Equity Curve

Filtering is a way to reduce the number of trades and provide better en­tries into the trade. Filtering can also produce a smoother equity curve. We saw that we could not improve smoothness (reduce standard error) with exits alone. Of course, you can argue that there might be other exits that work better, and you can check them all if you like.

In order to get a smoother equity curve, we will try changing the system design by introducing a filter. Because losses come from entries during consolidations, the primary benefit of filtering would be to elimi­nate some of the unprofitable entries. The penalty would be late entry into trends, resulting in lost profits. In some cases, the late entries would be near intermediate tops or bottoms, with the market reversing into the previous consolidation region. Such trades would trigger the initial stop loss orders. We explored how to use the RAVI filter with the 65sma-3cc system in chapter 3. You can use momentum-based filters or invent other filtering schemes.

Effect of Filtering on the Equity Curve 201

We tested a breakout system because breakout systems inherently do not produce entries during small consolidations. For example, a nar­row consolidation will not produce new 20-day highs or lows. There­fore, entries from the 65sma-3cc system in these areas would be elimi­nated. We used a simple filter based on the directional movement index (DMI) because it is a bit more sensitive than the average directional in­dex, or ADX. The purpose of the filter is just to reduce false breakouts, since breakouts during wide consolidations will occur without strong market momentum. The filter merely stipulates that the 14-day DMI be greater than an arbitrarily chosen level such as 50. For details on the construction of the DMI please refer to Wilder's book (see bibliography for reference).

We tested the system on DM data from March 1988 through June 1995 with rollovers on the twentieth day of the month before expiration, a $1,500 initial stop, and $100 allowed for slippage and commissions. The equity curves for the filtered and unfiltered system are shown in Figure 6.18.