How to Use Negative Filters to Manage Risk in Your Trades
Negative filters help you avoid risky trades by flagging situations where, despite meeting your entry criteria, something is off. These filters are used to reduce the amount of risk or skip a trade altogether.
What Are Negative Filters?
Most of the time we tend to look for reasons to enter a trade. However, good trading is just as much about the situations you choose not to trade as well. Rather than just focusing on the positive factors, it’s important to look for reasons to not open a trade - these would be our negative filters.
Some of these things are just automatically built into our trading, if there isn’t an entry, then you'll be unlikely to enter the trade. But what about situations where it does meet the entry criteria, but something just isn’t quite right?
This is where we can start to think about our negative filters. These help us filter out opportunities, or reduce our position size. They never add to a trade, they only take away from the trade.
The best way to explain this is with an analogy:
Imagine you’re driving a car. You know how to operate the car, so you know how to go faster or slower when the situation calls for it. You know all about the theory side and the rules of the road. You check your mirrors and look out of your window to understand the context of the situation. So you know when it’s fine for you to drive.
But will any of those things tell you when there’s a potential problem with the engine? When it’s overheating? When something needs to be changed?
Sometimes. Instead, you look to the little symbols that light up on your dashboard for that.
These are like our negative filters. You can’t use them to drive, but they can cause you to stop driving or to slow down in potentially dangerous situations when something isn’t quite right with the overall system or situation.
How to Apply Negative Filters
When we’re always focused on trying to identify what we need to see to open a trade, there may be other signals that we don’t pay attention to or notice. The role of the negative filter is to bring these things to your attention so you make the right adjustments.
For example, let’s say based on your analysis you decide you want to open a trade with a position size of 1%, however, your negative filter is showing you some uncertainty in the trade. Due to this you may decide to reduce the amount at risk to 0.6%, or even decide not open the trade at all.
Let's say you have a similar situation where the same entry criteria is being met and you want to risk 1%. This time, the negative filter isn’t warning you not to enter, you can enter with your full 1% at risk.
But how can you find negative filters for your trading?
Well, let’s say you’re assessing your trades and a lot of your losses are coming from times where the market showed specific characteristics. You may need to find something that will act as a negative filter to help you avoid situations when the market is like that.
For example, there’s an expression which says to never try and catch a falling knife and this is one I agree with. So if we get a setup, how can we know that it’s one we can go for, compared to a setup where we shouldn’t go for it and it would be like trying to catch a falling knife?
Our negative filter is going to help us. For this, we use our micro strategy and in particular we look at the momentum, trend and volume. These are only ever used as a negative filter and will show us when something is not right, where the momentum is likely to be too strong and push past our entry regardless of how strong our setup is.